Strong U.S. Dollar a Headwind to Earnings Growth
Dollar appreciation will result in lower short-term earnings growth but typically won’t have a meaningful effect on long-term intrinsic valuation.
The value of the U.S. dollar has been on a tear this year and has appreciated considerably compared with other currencies. For the year to date, the dollar's value compared with an index of currencies has risen 13%, including an appreciation of 14% versus the euro and 19% against the yen.
While this is great news for those in the United States traveling internationally, will it also meaningfully benefit investors? Unfortunately, it will not.
For companies that generate earnings in a foreign currency, those earnings are converted back into dollars for reporting purposes. In an environment where the dollar strengthens, the value of those foreign earnings is lessened.
For example, when converting from euros to dollars, the same amount of euros buys fewer dollars than a year ago. Thus, when converting earnings reported in euros to dollars, reported earnings will be lower than they were prior to the dollar’s advance, all else being equal. Conversely, for European companies converting dollars into euros, it will result in higher earnings, as a dollar is now worth a greater amount of euros.
Considering both the speed and magnitude of the dollar's appreciation, we expect that when companies with a significant amount of international sales report third-quarter earnings, it’s likely many will miss consensus estimates because of changes in foreign-exchange rates.
The types of companies most affected by exchange rates are those with a high percentage of their revenue derived in foreign countries and/or a significant differential between the currency in which their revenue is denominated and their expenses. That includes companies with:
In our valuation methodology, we consider foreign-currency effects to be largely one-time in nature. As such, the impact typically does not result in a significant change to our intrinsic valuation. However, if the shift in the foreign-exchange rates leads to a change in the underlying business dynamics, that would lead us to revise 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 forecast to generate over its lifetime.
In order to have a meaningful impact on our valuation, the model would need to incorporate a continual appreciation (or depreciation) of the foreign-exchange rate across several years. We do not try to predict exchange rates, and we assume those changes will normalize over the long term. In addition, our equity team typically focuses on the currency-adjusted results as that provides a better indicator of organic growth, underlying fundamental performance, and long-term earnings power.
For example, Mike Hodel, Morningstar’s director of media and telecom equity research, recently pointed out that Netflix (NFLX) increased the price of its standard offering in the United Kingdom by 10%. Yet, with the pound's weakness this year, Netflix's reported revenue per U.K. customer, in dollars, will decline around 4% during the third quarter. Given that much of Netflix's content costs, its biggest expense, are incurred in dollars, this currency weakness will directly hurt the company’s bottom line.
Over the long term, we expect Netflix will be able to raise prices in the U.K. to offset the pound's weakness thanks to the strength of its content pipeline, a key consideration behind our narrow Morningstar Economic Moat Rating, and the relatively low price of its offering compared with typical household income, which continues to rise as employees demand compensation for surging inflation.
Most companies look to minimize their risk to 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 production costs in the U.K. relatively attractive, allowing it to meet the demand of both U.K. and global viewers more efficiently.
A company may 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 out their currency risks over the short-term using derivatives or swaps. This hedging allows firms the time to make adjustments in either pricing and/or expenses to normalize their margins.
There are a multitude of factors that influence foreign-exchange rates. They range from the difference between interest rates and inflation, to capital flows or controls, to purchasing power parity. One factor pressuring the euro is the weakening economic outlook in Europe. As the conflict in Ukraine drags into its sixth month, rising energy prices, particularly for natural gas, are expected to have an outsize negative impact on industrial production across the region, especially in Germany.
Valuations may be revised when foreign-exchange rates affect underlying business fundamentals or are reflective of a change in the macroeconomic environment.
As the currency in which a product is priced is strengthening, customers may switch to a substitute product that is priced in a different currency. If customers discover the local product is a good substitute, U.S. firms could see permanent demand destruction. From a macro point of view, a depreciating currency may portend an imminent economic downturn, which in turn would lead to lower earnings, especially across cyclical sectors.
The table below shows examples of undervalued U.S. companies with a high percentage of foreign sales that have underperformed the broader market this year.
European companies that are undervalued with a high percentage of U.S. sales that have lagged the broader market include the following.
The third-quarter earnings season may see a higher percentage of companies than usual miss consensus earnings because of foreign-currency translation. While short-term traders may look to benefit from volatility immediately following an earnings release, long-term investors are better suited to focus on the outlook for the underlying long-term fundamentals of a company.
Understanding how changes in these fundamentals may affect the intrinsic valuation of a company will be more important to long-term investment success than trading short-term beats or misses in earnings.
David Sekera does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.