Lost in Translation?

Do currency exchange rates matter?

Brazilian Real priced in Dollars. Source: Bloomberg

More and more companies do business around the world. Toothpaste-maker Colgate-Palmolive has 30% of its sales in Latin America, but only 20% of its assets there. About half of their long-term assets are in Europe and the US. Clearly, they’re a global company with a global brand focused on basic needs. Their worldwide revenue growth has fluctuated, but their value has definitely grown over time. The shares have returned about 13% per year for the past 30 years.

But how do they get there? Under our accounting rules, foreign-currency transactions are essentially marked to market using the current exchange rate. Gains and losses – both realized and unrealized – are included in reported income. Foreign currency translation adjustments are broken out in a separate line item.

Because Colgate operates around the world, it has many functional currencies. These all have to be translated when the company reports its consolidated earnings. This can lead to some distortions. In 2014 and 2015 they reported over $600 million in losses because of the strong dollar. Their non-US operations didn’t return as much in dollar terms because those currencies have been falling. But is it really the case that the value of those businesses fell?

The answer has to do with the balance sheet. Because almost all of the company’s borrowings are issued and payable in dollars, there is some risk that a falling dollar makes it harder for them to service the debt. In theory, a company can hedge their borrowings through currency swaps and other off balance sheet activities, but – in Colgate’s case – gains from swaps don’t fully compensate for the currency translation losses. But the risk is small: the company is worth $72 billion, and only 8% of that is from debt – and very little is short-term debt.

Colgate Capital Structure. Source: Bloomberg

People often mistake accounting for bookkeeping. They think that financial statements are like a checkbook balance – you just have to add up the categories to get the final number. But accounting is more art than science. It’s critical to understand the assumptions that go into the calculations. Translation risk is real, and shouldn’t be ignored. But foreign currency effects aren’t likely to be sustained for more than a year or two, and may create market opportunities, if analysts are superficial in their treatment of a company’s bottom line.

There’s no substitute for careful, fundamental analysis of a company’s structure and operations. Too much aggregation can be hazardous to your financial health.

Douglas R. Tengdin, CFA

Leave a Reply

Your email address will not be published. Required fields are marked *