The value of the US dollar has fallen this year and appreciated considerably against other currencies. Since the beginning of the year, the value of the dollar against a currency index has increased by 13%, including an appreciation of 14% against the euro and 19% against the yen.

While this is great news for those traveling overseas to the US, will it also significantly benefit investors? Unfortunately, that will not be the case.

How do exchange rates affect income?

For companies that generate profits in a foreign currency, these profits are converted back into dollars for reporting purposes. In an environment where the dollar strengthens, the value of this foreign income is diminished.

For example, when converting from euros to dollars, the same amount of euros buys fewer dollars than a year ago. Thus, when converting income declared in euros into dollars, the income declared will be lower than it was before the rise of the dollar, all other things being equal. Conversely, for European companies that convert dollars into euros, this will translate into higher profits, as a dollar is now worth more euros.

Given both the speed and magnitude of the dollar’s appreciation, we expect that when companies with a large volume of international sales report third-quarter earnings, it is likely that many will miss the consensus estimates due to exchange rate fluctuations.

What attributes of these companies are most likely to be affected?

The types of businesses most affected by exchange rates are those with a high percentage of their revenues coming from foreign countries and/or a large discrepancy between the currency in which their revenues are denominated and their expenses. This includes companies with:

  • A significant portion of revenue denominated in a currency other than the one in which it reports earnings to shareholders.
  • Income and expenses denominated in different currencies, especially when the pricing of products or services is difficult to change in the short term.
  • Long-term contracts denominated in one currency but costs denominated in another, and especially those with fixed revenues but variable costs.
  • Products denominated in one currency can be substituted for products denominated in another currency.

What does foreign currency conversion do to intrinsic valuation?

In our valuation methodology, we consider currency effects to be largely one-time in nature. As such, the impact generally does not result in a material change to our intrinsic valuation. However, if the change in exchange rates leads to a change in the underlying business dynamic, this would cause us to review our valuation.

Our methodology is based on a discounted cash flow model that calculates the present value of a stock based on the projected free cash flow a company is expected to generate over its lifetime.

In order to have a significant impact on our assessment, the model should incorporate a continuous appreciation (or depreciation) of the exchange rate over several years. We do not attempt to predict exchange rates and assume that these changes will normalize over the long term. Additionally, our equity team typically focuses on currency-adjusted results, as this provides a better indicator of organic growth, underlying fundamental performance and long-term earnings power.

For example, Mike Hodel, director of media and telecommunications equity research at Morningstar, recently pointed out that Netflix (NFLX) increased the price of its standard offer in the United Kingdom by 10%. Still, with the pound weak this year, Netflix’s reported revenue per UK customer, in dollars, will decline by around 4% in the third quarter. Since much of Netflix’s content costs, its biggest expense, are incurred in dollars, this monetary weakness will directly hurt the company’s bottom line.

Long term, we expect Netflix to be able to raise prices in the UK to offset the weak pound thanks to the strength of its content pipeline, a key consideration behind our narrow Morningstar moat rating, and the relatively low price of its offer. compared to the income of a typical household, which continues to rise as employees demand compensation for soaring inflation.

A table of Netflix's price plan for the UK

Corporate actions to minimize currency risk

Most companies seek to minimize their risk of changes in exchange rates. For example, management will look to natural hedges such as matching foreign revenues and costs in the same currency. In the case of Netflix, a persistently weak pound could make UK production costs relatively attractive, allowing it to meet the demand of UK and global viewers more effectively.

A business can also issue debt in a foreign currency so that the interest cost of that money is denominated in the same currency as the revenue. Companies with significant global revenue exposures will typically take steps to hedge their short-term currency exposures using derivatives or swaps. This hedging gives companies time to make price and/or expense adjustments to normalize their margins.

Why has the dollar strengthened against other currencies?

There are a multitude of factors that influence exchange rates. They range from the difference between interest rates and inflation, to capital flows or controls, to purchasing power parity. The weakening economic outlook in Europe is one factor putting pressure on the euro. As the conflict in Ukraine enters its sixth month, rising energy prices, particularly natural gas, are expected to have an outsized negative impact on industrial production across the region, particularly in Germany.

A graph of natural gas prices in Europe since 2013.

When would exchange rates affect valuations?

Valuations may be revised when exchange rates affect underlying company fundamentals or reflect a change in the macroeconomic environment.

As the currency in which a product is priced strengthens, customers may opt for a substitute product that is priced in a different currency. If customers discover that the local product is a good substitute, American companies could see a permanent destruction of demand. From a macro perspective, a depreciating currency may portend an impending economic downturn, which in turn would lead to lower earnings, especially in cyclical sectors.

Which undervalued stocks have a high percentage of foreign sales?

The chart below shows examples of undervalued US companies with a high percentage of overseas sales that have underperformed the broader market this year.

Undervalued US companies with a high percentage of foreign sales.

Undervalued European companies with a high percentage of US sales that have lagged behind the broader market are as follows.

Undervalued European companies with a high percentage of US sales.

The third-quarter earnings season could see a higher percentage of companies than usual miss consensus results due to foreign currency translation. While short-term traders may look to benefit from volatility immediately after the earnings release, long-term investors are better placed to focus on the outlook for a company’s long-term underlying fundamentals.

Understanding how changes in these fundamentals can affect a company’s intrinsic valuation will be more important to successful long-term investing than trading short-term beats or profit losses.

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