Ignoring Currency Risk
A European pharmaceutical company reports euro-denominated earnings of 1.5 billion euros in 2025, earning 12 euros per share. An American investor converts that at the current exchange rate of 1.10 USD/EUR and calculates $13.20 in EPS. They build a valuation model assuming earnings grow 8% annually. The stock is trading at $95, giving a P/E of 7.2x—a bargain.
They buy 100 shares for $9,500. Two years later, the euro has weakened to 0.95 USD/EUR. The company has grown earnings to 1.76 billion euros (7.9% per year, on track), but when converted to dollars, earnings are now $10.94 per share—lower than the $13.20 they used in their model.
The stock is now $87. They have lost money despite the company's earnings growing exactly as they modeled. They ignored currency risk.
Currency movements can erase or amplify returns regardless of whether the underlying business performs as expected. Ignoring this risk is especially dangerous for US investors buying foreign stocks.
Key takeaways
- Foreign currency exposure creates a second layer of risk separate from business fundamentals; a company can outperform while the investor underperforms due to currency headwinds.
- A dollar-strengthening environment reduces returns for US investors holding foreign stocks; a dollar-weakening environment amplifies returns.
- Currency hedging is expensive; most individual investors do not hedge, making them unwilling bearers of FX risk.
- Companies with unhedged foreign revenue (most companies) face compressed earnings if the currency weakens, even if local-currency earnings are stable.
- Valuations derived in one currency (euros) and consumed in another (dollars) require careful handling to avoid overpaying.
Why currency risk matters to valuations
When you buy a foreign stock as a US investor, you make two bets:
- The business bet: The company's revenue, margins, and cash flow will grow as expected.
- The currency bet: The local currency will maintain its value relative to the dollar.
If both bets win, you earn double. If the business wins but the currency loses, your returns are muted. If the business loses and the currency loses, you lose twice.
Most investors focus on bet #1 and ignore bet #2. They look at the company's local-currency valuation metrics (P/E, EV/EBITDA) and calculate intrinsic value in the local currency. They then convert that to dollars at the current exchange rate and conclude the stock is cheap or expensive. This is a mistake because the current exchange rate is not necessarily the fair rate going forward.
For example, in 2015, the Swiss franc strengthened sharply against the euro. Swiss companies with significant euro revenues suddenly saw their reported earnings decline in francs despite the underlying business performing well. A Swiss investor who had valued a euro-facing company at fair value at the 2014 exchange rate overpaid in 2015 when the franc strengthened.
The mechanism: how currency affects earnings
When a company operates internationally, currency fluctuations hit earnings in multiple ways.
Revenue conversion: A multinational earns 100 million euros from European operations. If the exchange rate is 1.10 USD/EUR, that is $110 million in reported revenue. If the euro weakens to 0.95 USD/EUR, that same $100 million euros converts to $95 million. The company earned the same in euros but less in dollars. For a US-listed company or a foreign company reporting in dollars, this directly reduces reported EPS.
Earnings translation: A European subsidiary earns 50 million euros in operating income. When the parent company (US-based) consolidates results for its dollar-denominated financial statements, it translates those euros at the average exchange rate for the period. If the euro weakens during the year, the translated earnings are lower, even if the subsidiary's margins improved.
Balance sheet exposure: Foreign subsidiaries hold euro-denominated assets and liabilities. When the euro weakens, the value of those assets (in dollars) declines, creating a foreign exchange loss. This is recorded in other comprehensive income or directly against equity, reducing book value.
Competitive effects: Currency movements affect the price competitiveness of imports and exports. If the dollar strengthens, US companies can export more cheaply (good for US exporters, bad for foreign competitors). A foreign company facing import competition from the US suddenly sees its products become less price-competitive if its home currency weakens.
How to quantify currency exposure in a valuation
The first step is to identify how much of a company's revenue comes from foreign markets. This is disclosed in company filings. For example:
- Nike: 60% of revenue is international
- LVMH (French luxury): 75% of revenue is international
- Nestlé (Swiss food): 95% of revenue is international
A company with high international revenue is exposed to currency risk. A company with most revenue in its home currency is less exposed.
Next, estimate the currency exposure in dollars. If a company earns $1 billion in revenue and 60% is international (so $600 million), and 50% of that international revenue is euro-denominated (so $300 million), then the company has $300 million in revenue exposed to euro weakness. If the euro weakens 10%, that translates to $30 million in lost revenue in dollar terms.
For valuation purposes, this matters because:
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Project currency-adjusted earnings: Do not assume reported earnings will grow at a stable rate if the currency is volatile. Instead, project local-currency earnings and local-currency growth rates separately, then translate at the appropriate exchange rate.
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Test sensitivity: Calculate valuations at different exchange rates. If the base-case valuation assumes 1.10 USD/EUR but the range is 0.90-1.15, calculate valuations at 0.90, 1.00, and 1.10 to see the impact. A stock that is "cheap" at 1.10 might be "expensive" at 0.90.
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Use a risk-adjusted discount rate: Because currency risk is a form of volatility, it increases the appropriate discount rate for a foreign investment. Instead of using a 7% discount rate, use 8-9% if currency risk is material.
Real-world example: the Nike effect
Nike's earnings have been under pressure from 2022-2025 due to several factors, but one that is often overlooked is currency headwinds. The euro weakened significantly against the dollar from 2022 to 2024. Nike earns substantial revenue in Europe.
In 2022, Nike earned approximately $5.05 per share. Without currency headwinds, the company might have achieved $5.40 per share (on same operational performance). In 2023, the company reported $5.95 per share, but again currency was a headwind; local-currency earnings were higher. Investors who did not account for currency might have concluded the company was underperforming or that valuation was cheap; in fact, the operational business was stable, but the dollar was strong.
Currency is not a valuation "add-on" that investors can safely ignore. It is a material component of returns.
The cost and complexity of hedging
Some multinational companies and investors hedge their currency exposure. A hedge typically means selling future currency at a locked-in rate, eliminating the upside and downside from currency movements. This costs money (the difference between the spot and forward rates, plus transaction fees).
For an individual investor, hedging is rarely practical. Hedging instruments (currency futures, options) require active management and carry their own costs. Most individuals simply accept the currency risk as part of owning a foreign stock.
This is a rational choice only if the investor:
- Understands the currency risk they are bearing.
- Has sized the position appropriately (smaller position if currency risk is high).
- Is compensated for the risk in the form of higher expected returns.
Many investors fail at #1 and #2. They buy a foreign stock thinking they are buying a stable, established business, not realizing they are also taking a currency bet.
Currency risk in emerging markets
The problem is even more acute in emerging markets. The Indian rupee, Brazilian real, and Mexican peso are all more volatile than major developed currencies. A US investor buying a high-quality Indian company might find that currency headwinds wipe out years of earnings growth.
For example, investors who bought Indian IT service companies at high valuations in 2020-2021 found that the rupee weakened 10% against the dollar by 2024. Combined with tighter US tech spending, the stocks fell 30-40% despite the companies' operational metrics being relatively stable.
Emerging market stocks should trade at lower valuations than developed market equivalents, partly to compensate for currency risk. If an Indian company trades at a P/E equivalent to a US company, the Indian stock is likely overpriced on a risk-adjusted basis.
Currency risk in long-term models
This is where most valuation models fail. A typical DCF model projects earnings for 5-10 years, then assumes a terminal growth rate. The earnings are in a specific currency (euros, if the company is European). The discount rate is set to reflect the business risk of that company.
But the discount rate should also reflect currency risk. Here is the problem: many analysts use a single discount rate derived from the company's local beta and the local market risk premium. They do not adjust upward for currency risk.
A better approach: use a discount rate that explicitly includes currency risk. For a developed-market company with some international exposure, add 1-2% to the risk-free rate. For an emerging-market company, add 3-5%.
Or, hedge the currency in the model. Project local-currency earnings, assume they grow at the expected rate in local currency, then convert to dollars using a long-term equilibrium exchange rate (not the spot rate). This forces you to be explicit about your FX assumption.
The dollar's long-term strength problem
The US dollar has been strong on average over the past 20 years, particularly since 2010. This has benefited US-based investors holding foreign stocks—but it has also obscured the reality that most non-US companies have faced currency headwinds.
A European company that earned 100 euros per share in 2010 and 115 euros per share in 2024 (15% growth in euros) might have seen the dollar-converted earnings fall from $130 to $109 (assuming 1.30 and 0.95 exchange rates). Local growth of 15% became global loss of 16%.
Going forward, if the dollar weakens (a realistic scenario given high US debt and deficits), this tailwind will reverse. Foreign investors will see currency tailwinds, while US investors holding foreign stocks will see headwinds. This could be a multi-year trend.
How to avoid currency pitfalls in valuation
1. Separate business analysis from currency analysis. Project the company's operational performance in its home currency. Revenue growth, margin expansion, and cash generation should be analyzed in the local currency. Then, separately, apply an exchange rate assumption.
2. Use a long-term equilibrium exchange rate. Do not use the spot rate for a 5-10 year projection. Instead, estimate the long-term fair value of the currency based on purchasing power parity (the idea that a dollar should buy the same goods in the US and abroad). This is more stable than spot rates.
3. Stress-test at multiple exchange rates. Create scenarios:
- Base case: Assume current exchange rate holds.
- Bull case: Assume currency strengthens (better for US investors holding foreign stock).
- Bear case: Assume currency weakens. Calculate valuations in each scenario and weight by probability.
4. Adjust for currency exposure explicitly. In the income statement or cash flow projection, line-item the expected impact of currency headwinds or tailwinds.
5. For companies with hedging programs, understand them. Some multinationals hedge a portion of their FX exposure. If the company hedges 50% of euro exposure, that reduces but does not eliminate currency risk. Read the notes to understand.
Common mistakes
Mistake 1: Ignoring currency entirely. This is the most common error. An investor values a foreign company and does not consider that currency changes can erase returns.
Mistake 2: Assuming currency is stable. Major currency pairs can move 10-20% annually. Over a 5-year projection, cumulative moves of 30-40% are common. This is not stable.
Mistake 3: Using spot rate for long-term projections. Spot rates reflect today's sentiment. Forward rates and PPP-based estimates are better for long-term models.
Mistake 4: Buying at peak currency strength. If the dollar is unusually strong (as it was in 2015 and 2022), foreign stocks are effectively more expensive for US investors. Waiting for currency to normalize before buying can improve returns.
Mistake 5: Double-discounting for risk. If you use a high discount rate to account for currency risk, do not also reduce the terminal growth rate. Pick one method.
FAQ
Q: Should I hedge currency exposure in my personal portfolio?
A: For most individuals, no. Hedging is expensive and requires active management. Instead, be aware of the risk, size your positions accordingly, and understand that international holdings will have volatility from currency as well as business fundamentals.
Q: If I buy a foreign company at a low P/E, am I protected from currency risk?
A: No. A low P/E means the stock might be cheap on business fundamentals, but currency risk is independent. The stock could stay cheap by P/E but fall 20% for you due to currency headwinds.
Q: Is currency risk different for different types of companies?
A: Yes. An export-oriented company (like a pharmaceutical with most sales abroad) has currency risk on the revenue side. A company whose main market is domestic but which has imported costs has currency risk on the cost side. Understand the specific exposure.
Q: Do currency-hedged ETFs solve this problem?
A: Partially. Currency-hedged international ETFs attempt to remove currency exposure, but they do so imperfectly and at a cost (the difference between spot and forward rates). They are useful if you want pure business exposure, but they are not free.
Q: How much currency movement can a company's earnings absorb?
A: A 10% currency move typically impacts reported earnings by 2-5% for a diversified multinational and 5-10% for a company with concentrated exposure to one foreign currency.
Q: What is the relationship between interest rates and currency?
A: Higher interest rates in a country tend to strengthen that country's currency (investors seek higher yields). So rising US rates tend to strengthen the dollar, which is a headwind for US investors in foreign stocks.
Related concepts
- Understanding foreign exchange exposure in financial statements
- Translating foreign subsidiary earnings
- Currency effects on cash flow
- Sensitivity analysis and stress testing in DCF models
Summary
Currency risk is a distinct, often-ignored component of investing in foreign stocks. When you buy a European company, you are making two simultaneous bets: that the company's business will perform well, and that the euro will hold its value against the dollar. A company can meet its operational targets while still delivering poor returns to US investors if the currency weakens. Valuations derived in a foreign currency must account for currency risk through a higher discount rate, stress testing at multiple exchange rates, or explicit FX assumptions. The cost and complexity of hedging mean most individual investors bear uncompensated currency risk. The best approach is to use long-term equilibrium exchange rates in models, test sensitivity at different rate levels, and size foreign positions with awareness that currency can add or subtract 2-5% annually from returns. Ignoring currency means ignoring a material component of risk and return.