Market value of foreign direct investment position

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• Background
• International perspective
• General methodology
• Methodology for Canadian direct investment abroad
• Methodology for foreign direct investment in Canada
• Data characteristics
• Provisional results
• Further developments

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Background

A multi-year initiative to improve the balance sheet information for all sectors of the economy started in the fall of 2002. The first step in improving the International Investment Position (IIP) was to convert to quarterly frequency at the time of the first quarter 2003 release in June 2003.

In June 2004, additional series measuring portfolio investment at market value were added to the IIP quarterly release. Data on Canadian and foreign stocks as well as bonds were made available at market value.

At the same time there has been renewed debate at the international level on what methods are appropriate to estimate the market value of unlisted equity investments, including inter-company (direct) investment. A very large part of direct investment both into and out of Canada is privately held and therefore no market value is regularly available. The international community has recently agreed on a short list of acceptable approaches for estimating the market value of these holdings but there is, as yet, little experience in applying them.

To follow international standards, all components of the IIP should reflect current period prices and the conversion of foreign direct investment to market value estimates is the largest obstacle yet to be overcome. In an effort to improve Canadian estimates and to contribute to the international effort on improving market value estimates, this release provides aggregate provisional estimates of foreign direct investment (FDI) at market value.

This note provides an overview of the methods as well as the provisional results for market value FDI positions using one of the internationally recognized methods. However, there remain a number of challenges and this note is being released to elicit comments from the user community as well as from other compilers. Over the coming year, the methodology will be improved, estimates extended back further in time and quarterly FDI estimates compiled.

International perspective

Market prices are the prescribed basis for valuation in the international accounts. Market prices refer to current exchange value, i.e., the values at which goods and other assets, services, and labours are in fact exchanged. Stocks of financial assets and liabilities should be valued as if they were acquired in market transactions on the balance sheet reporting date.

Many financial assets are traded in markets on a regular basis and therefore can be valued by directly using the price quotations from these markets. For financial assets and liabilities that are not traded in financial markets, or are traded only infrequently, it is necessary to estimate fair values that, in effect, approximate market prices.

In most countries, only book value is available to IIP compilers and users. Given that market value is the appropriate measure for FDI, these countries have to develop an approach to convert book value FDI estimates to reflect current period prices. No single approach has been approved or implemented¹.

Recent international efforts have resulted in the compilation of a short list of appropriate approaches. The exact choice of method is left to the compilers depending on data availability and market conditions in each economy.

Some countries already produce market value estimates for foreign direct investment. Australia asks respondents via their survey process to provide an estimate of their investments at market value. The United States uses an aggregate approach based on stock exchange prices. Ireland and Greece are other examples where stock exchange prices are used as a source to compile market value estimates.

General methodology

The Canadian methodology to convert the book value estimates of FDI is based on the use of capitalization ratios for both listed and unlisted companies with some restrictions such as the exclusion of small companies. At this point, only two total aggregates (one for outward, one for inward FDI) are available as provisional annual estimates.

The global approach can be summarized as follows: Capitalization ratios (market value divided by book value) are applied to the equity portion of the position, the value of the debt portion is left unchanged and equals to book value. For equity, if the Canadian or foreign subsidiary or affiliate is listed on a stock market, its appropriate capitalization ratio is used; however, if the subsidiary or affiliate is not listed on a stock market, a capitalization ratio is imputed by taking the ratio of the parent or the Canadian industry average ratio.

Construction of capitalization ratios

The capitalization ratios come from the same sources as the ones applied to estimate the market value of Canadian portfolio investment. They are based on the Toronto Stock Exchange (TSX) data reconciled to a Statistics Canada enterprise survey². A capitalization ratio was established for each individual company at every period-end using the following formula:

Description

Where:
MktCap - Market capitalisation from the TSX;
share - Share capital (common and preferred shares);
cs - closing balance of contributed surplus (inclusive of appraisal credits and other equity changes);
re - closing balance of retained earnings.

This method gives a set of ratios for listed companies. These ratios are also used to generate Canadian industry average ratios used for unlisted companies. These averages include all Canadian listed firms except for extreme ratios that were considered outliers³.

Treatment of small companies

FDI investments, both inward and outward, are relatively skewed. Therefore at one end of the distribution there are a small number of enterprises that account for most of the value while a large number of enterprises at the bottom of the distribution account for very little value. Roughly 80% of FDI companies representing 2.5% of total FDI equity positions were considered small. The market value of these small firms has been left equal to book value. While the impact of the small companies is not significant, it may well be that the book value, as defined for the Balance of Payments surveys (including accumulated earnings), is a reasonable estimate of market value for these small firms.

Automobile sector

The high degree of foreign ownership coupled with the small number of automobile manufacturers in Canada results in industry capitalization ratios that are not considered representative. For this sector, market value estimates for both foreign direct investment in Canada and Canadian direct investment abroad were based on information for the global parent company.

Methodology for Canadian direct investment abroad

More specifically, the methodology for estimating Canadian direct investment abroad (CDIA) at market value is:

• Foreign affiliates listed abroad: a capitalization ratio was applied to the equity portion of the FDI position⁴. Very few cases were based on this method due to a lack of information. These ratios come from an external private source;
• Foreign affiliates not listed on a foreign market with its Canadian parent listed on the TSX: at the company level, the capitalization ratio of the Canadian parent was applied to the equity value of its foreign affiliates (only when the Canadian parent was in the same industry). If the affiliate abroad was in a different industry than the Canadian parent, an industry average capitalization ratio based on the Canadian market was used;
• Other unlisted companies: an industry average ratio based on the Canadian companies listed on the TSX was used.

As a consistency check, the market capitalization of the Canadian parent is compared to the sum of market value of all its foreign subsidiaries and its participation in foreign associates.

Methodology for foreign direct investment in Canada

The methodology for estimating foreign direct investment in Canada (FDIC) at market value is:

• Canadian affiliates listed in Canada: at the company level, the capitalization ratio was applied to the equity portion of the FDI position⁵;
• Other unlisted companies: industry average ratios based on Canadian companies were applied to the Canadian affiliates' equity value.

Data characteristics

For outward FDI (Canadian direct investment abroad), 40% of the total market value position of the foreign affiliates is based on the capitalization ratio of the Canadian parent and about 40% are based on the Canadian industry average. There were a number of cases where the estimated market values for the foreign affiliates exceeded the total of the Canadian parent. In these cases, the values are reduced to meet this constraint. These cases may reveal inconsistencies in the data used for these estimates⁶. However, it is also possible that the market has placed a lower value on this company than the accounting models would suggest⁷. These inconstencies will be further investigated over the coming year.

For inward FDI (foreign direct investment in Canada), very few Canadian affiliates of foreign companies are listed on the Canadian stock market. On average, 85% of the total inward market value position is based on industry average ratios. Until the potential data inconsistencies mentioned above are resolved, it is assumed that the data on inward FDI suffers from the same degree of inconsistency and have been adjusted accordingly.

Provisional results

New estimates are available for the years 2002 to 2005. Canadian direct investment abroad at market value totaled $808.3 billion at the end of 2005. Over the three year period Canadian direct investment abroad at market value increased by 41%. At the same time, the book value estimates increased by only 7%.

On the other hand, foreign direct investment in Canada at market value was $771.3 billion at year-end 2005. While the book value estimate increased by about 17% over the three year period, the market value estimate increased by 47%. Almost half of this increase was recorded between 2004 and 2005.

Table 1 Foreign direct investment positions at year-end

	2002	2003	2004	2005
	millions of dollars (except ratios)
	Canadian direct investment abroad
Book value (BV)	435,494	411,887	451,438	465,058
Market value (MV)	572,624	632,790	705,799	808,256
MV/BV ratio	1.31	1.54	1.56	1.74
	Foreign direct investment in Canada
Book value (BV)	356,819	364,708	380,951	415,561
Market value (MV)	525,200	588,444	630,536	771,327
MV/BV ratio	1.47	1.61	1.66	1.86

The table below presents a comparison between Canadian and U.S.⁸ estimates of market value to book value ratios derived from the published positions. Ratios are similar for both countries, over the period.

Table 2 Market value to book value ratios at year-end

	2002	2003	2004
	ratios
	Canadian estimates
Canadian direct investment abroad	1.31	1.54	1.56
Foreign direct investment in Canada	1.47	1.61	1.66
	U.S. estimates (derived)
U.S. direct investment abroad	1.25	1.52	1.59
Foreign direct investment in the U.S.	1.51	1.74	1.76

Further developments

These market value estimates are a first attempt to provide additional analytical data to FDI data users. Over the coming year work will proceed to refine the approach described above, quarterly market value estimates will be estimated, and the time series will be extended back to 1990. More emphasis will also be devoted to the analysis of individual companies and to the country distribution of foreign direct investment.

The first aspect that will be covered is the review of all major transactions. For listed and especially for unlisted companies, a recent transaction price can provide a very good approximation of the current market value especially if the transaction is close to the evaluation period and is between independent parties. The transaction price will be used to approximate the latest market value of some companies.

Another important aspect to cover is the trend of foreign market indexes. For Canadian direct investment abroad, the use of ratios based on the Canadian parent may not reflect the trend observed in foreign markets. The possibility of using foreign stock indexes to adjust the market value of Canadian direct investment abroad in major countries will be examined in future research. The United States revalue U.S. parents' equity in foreign affiliates using end-of-year stock price indexes and adjusting for exchange rate effects, changes in annual investment and correcting for the effect of retained earnings on stock market prices during the year.

As there is relatively little international experience in using these techniques, further consultations with other compilers and international agencies will be undertaken.

When a full set of FDI at market value, along with quarterly estimates, becomes available, it will be included in the International Investment Position (IIP) tables. At that time a net IIP position at market value will be presented in the main IIP table.

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1. No single approach has been prescribed by international standards. Flexibility is encouraged in the choice of methods and no ranking of methods has been established.
2. Data from the Industrial Organization and Finance Division Quarterly Financial Statistics Survey (book value portion of the equation) were reconciled to the listed shares on the Toronto Stock Exchange (TSX) (market value portion of the equation).
3. Ratios over 10 and under 0.5 were considered outliers.
4. This is the position as reported on the Balance of Payments surveys.
5. This is the position as reported on the Balance of Payments surveys.
6. This is particularly the case for the Canadian banking sector. Consequently, it was decided with the release of these first set of market value estimates, to keep this sector at book value until the data is further investigated.
7. There could also be cases where the market value is well above the value from accounting models but no assessment of such cases has been attempted.
8. U.S. ratios are calculated from (market value estimates / historical cost estimates) foreign direct investment data published in the Survey of Current Business, September 2005, Bureau of Economic Analysis.