Financial and institutional determinants of the price dynamics of the Russian stock market

Picture 5. Dependence of the P/E multiplier on the export concentration

Picture 6. Dependence of the P/E multiplier on the corruption perception

All the indexes have no direct influence on the P/E multiplier. However, the P/E multiplier is a function of the cost of equity which has these indexes in the regression. The graphs (Picture 7, Picture 8) shows the impact of changing the indexes on the cost of equity.

Picture 7. Dependence of the cost of equity on the export concentration

There is a positive correlation between the cost of equity and the export concentration index. The difference in the export concentration index of the Russia market (0.38) from the United States one (0.08) leads to an increase of the cost of equity for the Russia market by 0.41% (the slope is 0.0204).

Picture 8. Dependence of the cost of equity on the corruption perception

The cost of equity has a strong relationship with the corruption perception index. Russia has corruption perception index on 0.31 level when United States takes the value of 0.1. The change of the index will have impact of the cost of equity about 1.18% (the slope is -0.056).

Overall, the export concentration and corruption perceptions indexes give around 1.6% to the cost of equity to Russia market. To calculate the cost of equity the two stage discount model was used. According to this model (Equation 11) the cost of equity is a function of the P/E multiplier observed, growth rate forecasts, return on equity and estimated convergence coefficients (Table 9).

The following table shows the cost of equity estimations ranged by the developed and developing countries.

Table 15. Estimated cost of equity

Russia takes the third place from the end after Peru and Argentina by the cost of equity value. This is a consequence of the high values of the risk factors, especially volatility of returns beta, investment climate and economic structure indexes, high stock's illiquidity and average firm's size.

3.4 The estimated target P/E multiplier

The P/E multiplier target values for the countries are estimated using figured the cost of equity in the section 3.5 by the two stage discount model.

The Table 16 shows estimated P/E multiplier for all countries comparing with the P/E multiplier values which were obtained by using the Damodaran's cost of equity for the 2016 year. The model provides higher fitness and less deviation percentage.

Table 16. Comparison of the estimated P/E multiplier with observed and Damodaran values

In the graph (Picture 9) estimated P/E multiplier for United States is shown. In order to prove usage of the selected risk factors the P/E multiplier is estimated by the Damodaran's cost of equity values in the same graph.

Picture 9. Estimated and Damodaran's P/E multiplier for United States

The target level of the P/E multiplier is less volatile as it calculated by the fundamental characteristics that are relatively stable. Moreover, the indexes are calculated annually. On average, the estimated values correspond to the observed one excluding the time of the world crisis in 2009.

Damodaran model estimates the equity risk premium by summing country risk premium and market risk premium. The market return and beta are calculated relative to MSCI index. The beta estimated for five historical years as it gives the highest R². The weighted risk-free rate is used as risk-free rate. The country risk premium is a spread of United States and i countries government bond yields multiplied by relative equity volatility which is calculated as the ratio of the emerging equity index's standard deviation and the emerging bond index's standard deviation.

The Damodaran model estimations gives much more volatile values and less corresponds to the observed P/E multiplier. In the case of United States the country risk premium equal to zero and market risk premium takes values around five percent.

In the same way for Russia market the P/E multiplier is estimated by the model and by Damodaran's cost of equity values. They are presented in the graph (Picture 10)

Picture 10. Estimated and Damodaran's P/E multiplier for Russia

The results are the same as for United States. The model better correspond to the observed P/E multiplier than the Damodaran model. The country risk premium is calculated as difference between Russia and United States government bond yields multiplied by the relative equity volatility which is the ratio of the equity and bond index standard deviations.

Picture 11. The observed discount of Russia market comparing with the United States (right scale)

The observed discount of Russia P/E multiplier is given in the graph (Picture 11). It takes values between 10% and 75%, the average one is around 70% for the 2013-2016 period. In order to determine the quality of the proposed model the following metric is used:

The first step we should calculate the discount by the obtained main model. As residual discount could take values in a range of zero and infinity mathematical manipulation should be done in order to get the variable in a range of zero and one. The function

is used to this task.

Picture 12. Observed and estimated discount of Russia comparing with United States

The graph (Picture 12) provides the estimated and observed discount of Russia market comparing with United States. According to the proposed metric the percentage of fit is equal to 84%. It means that the model explain 84% of the observed discount.

In the research the cost of equity is estimated for the considered countries and the target P/E values are obtained using two stage discount model. The target values are better agreed with the historical data comparing with the P/E multiplier values which were obtained by using the Damodaran's cost of equity estimations and at the same time they depend only on the fundamental factors. Thus, the proposed methodology could be used in the P/E target level estimations. However, at the time of crisis and sharp changes of the economy the target values are smother comparing with the factual values.

Conclusion

In the paper the risk factors which lead to a huge discount of the Russia stock market to the United States one are investigated. The fundamental factors and theoretical models which were studied in the previous researches were used. These factors were analyzed and proved to be significant in the developed and developing countries.

In accordance with the theoretical and empirical studies it was hypothesized that the observed discount is a consequence of the existing additional risks of Russia market. To determine these risks a methodology for estimating the cost of equity by using the observed P/E multiplier values is proposed. The obtained estimates confirmed the hypotheses: the cost of equity depends on the average firm's size, stock's illiquidity, indicators of the country's investment climate and economy structure. Significant concentration of the export due to the lack of competitiveness of the economy leads to an increase risks of the investor. Since the decline in demand for exported goods will have negative consequences for the majority of companies operating in this country.

The low corruption perception index indicates an increase in the risk that companies will face bribery or other corrupt practices in doing business. This leads to less effective market.

These statements have been confirmed by the empirical research which contain developed and developing 42 countries. This research gives the answer to the question posed in the paper: the observed discount of Russia market is large due to the high risks which could be explained by the corruption level, economy structure, stock's illiquidity and average firm's size. In the study the two stage discount model is used to estimate target P/E multiplier. The fitness analysis test of obtained estimations allowed us to conclude that the model is in a good agreement with the historical data. It is also worth noting that the calculations of the target values are based on the fundamental determinants and this makes possible track the changes of the P/E multiplier. The obtained results make possible to make more feasible company valuation and determine the target discount level of the market which makes possible to diagnose underestimated/overestimated markets.

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