Can Chinese companies live up toinvestor expectations?In a reversal of long-term trends, Chinese companies now enjoy avaluation premium over their peers in developed markets. What’schanged?

May 2011 • David Cogman and Emma Wang

Source: Corporate Finance Practice

A re Ch in ese a n d oth er com pa n ies in em er g in g m a r kets fin a lly

g ett in g th e r espect th ey deser v e? Histor ica lly , th ey ’v e tr a ded a t

a discou n t on a ll m etr ics of v a lu a t ion —ty pica lly , in th e r a n g e of

2 0 to 3 0 per cen t . 1 Ev en a s th e u n der ly in g Ch in ese econ om y

dev eloped a n d th e sh a r es of th ese com pa n ies beca m e a

com m on ly a ccepted in v estm en t opt ion , n eith er in st itu t ion a l n or

r eta il in v estor s qu ite sh ook th e per cept ion th a t su ch secu r it ies

w er e g en er a lly r isky . Yet if th e A sia n fin a n cia l cr isis of th e la te

1 9 9 0s r ein for ced th a t belief, th e cr edit cr isis of 2 007 m a y h a v e

r ev er sed it . In deed, com pa n ies in sev er a l m a jor em er g in g

m a r kets n ow tr a de a t a pr em iu m to th eir peer s in dev eloped

m a r kets.

It ’s t r u e th a t in th e w a ke of th e cr isis a n d th e en su in g r ecession ,

in v estor s h a v e ta ken n ote of th e g r ea t r eba la n cin g of econ om ic

pow er , sh ift in g fr om West to Ea st , a n d h a v e r eth ou g h t lon g -h eld

beliefs a bou t th e r ela t iv e secu r ity of a sset cla sses in both

dev eloped a n d dev elopin g econ om ies. Bu t a n im por ta n t qu est ion

a r ises: h a v e com pa n ies in em er g in g m a r kets ch a n g ed or ju st

in v estor s’ per cept ion s of th em ? Th e qu est ion is a pt in a n u m ber

of em er g in g m a r kets, in clu din g Br a zil, In dia , a n d Ru ssia , bu t it ’s

pa r t icu la r ly so in Ch in a , w h er e th e r ev er sa l in pr em iu m s is

m ost n ot icea ble. If th ese v a lu a t ion s r eflect in v estor s’

ex pecta t ion s for fu tu r e g r ow th a n d r etu r n s, a r e th er e v a lid

r ea son s to believ e th a t th ose of Ch in ese com pa n ies h a v e

im pr ov ed th r ou g h th e r ecession ? Or a r e in v estor s a lr ea dy

a ssu m in g a n im pr ov em en t in econ om ic r ea lit ies? Econ om ic da ta

su g g est th e la t ter .

A shift in valuation

In em er g in g m a r kets, th e h istor ica l discou n t of com pa n ies w a s

g en er a lly in lin e w ith th eir per for m a n ce. A s w e obser v ed a few

y ea r s a g o,2 em er g in g m a r kets m a y ty pica lly h a v e ex h ibited

h ig h er g r ow th bu t a lso h a d m u ch low er r etu r n s on ca pita l th a n

th eir Wester n peer s. Th is differ en ce a lm ost com pletely ex pla in s

th e differ en ce in v a lu a t ion m u lt iples. Fr om 2 006 to 2 01 0, ou r

a n a ly sis fou n d th e a v er a g e r etu r n on equ ity (ROE) of Ch in ese

com pa n ies to be six per cen ta g e poin ts below th a t of US

com pa n ies—a g a p th a t r em a in ed ev en w h en th e pr ofita bility of

US com pa n ies fell.3 Th is g a p a lon e w ou ld im ply a pr ice-ea r n in g s

r a t io (P/E) m u lt iple 2 0 per cen t low er . Ev en if com pa n ies in th ese

m a r kets h a d been g r ow in g th r ee to fiv e per cen ta g e poin ts fa ster ,

th eir low er r etu r n s on ca pita l st ill w a r r a n ted a P/E discou n t of

1 0 to 1 5 per cen t r ela t iv e to th eir dev eloped-m a r ket

cou n ter pa r ts. Th is discou n t h a s r ev er sed in som e m a r kets in th e

w a ke of th e econ om ic cr isis. Com pa n ies in Ch in a , a lon g w ith

th ose in In dia a n d La t in A m er ica , n ow tr a de a t a pr em iu m to

com pa n ies in dev eloped m a r kets (Ex h ibit 1 ).

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In 2 008 –09 , it w a s qu ite ea sy to w r ite th is dev elopm en t off a s a

tem por a r y , liqu idity -fu eled a n om a ly . In v estor s w a n ted to be

a n y w h er e bu t dev eloped m a r kets. Wh ile com pa n ies in

dev elopin g on es st ill h a d less tr a n spa r en t fin a n cia l r epor t in g a n d

w ea ker g ov er n a n ce, th ey g en er a lly h a d less r isky ba n kin g

sy stem s a s a r esu lt of str on g er g ov er n m en t con tr ols. A lso,

g ov er n m en ts didn ’t h a v e to pr op u p in du str ia l com pa n ies, a s th e

Un ited Sta tes did in th e a u tom otiv e sector . Som e m a jor

em er g in g m a r kets, w ith th eir pr om ise of h ig h g r ow th a n d low er

cost ba ses, w er e per ceiv ed a s sa fer th a n dev eloped m a r kets

—th ou g h n ot a ll em er g in g m a r kets w er e equ a lly fa v or ed. On ly

Ch in a a n d In dia a ch iev ed th e v a lu a t ion pr em iu m for a

pr otr a cted per iod; com pa n ies in Br a zil a n d Ru ssia tr a ded a t a

discou n t to th ose in dev eloped m a r kets th r ou g h ou t th e r ecession .

In Ch in a , th e sh ift in v a lu a t ion s h a s n ot pr ov ed to be a n

a n om a ly . Th ey r em a in a t a 2 0 to 3 0 per cen t pr em iu m a bov e

th ose in th e Un ited Sta tes a n d th e Eu r opea n Un ion —a n d th e g a p

is n ot ex pla in ed by a differ en t in du str ia l str u ctu r e. On a n

in du str y -by -in du str y ba sis, th e g a p is ev en la r g er . In 2 008 , P/E

r a t ios for Ch in ese com pa n ies in th e in du str ia l, con su m er g oods,

a n d fin a n cia l sector s w er e 9 per cen t low er , 2 2 per cen t h ig h er ,

a n d 3 3 per cen t low er , r espect iv ely , th a n th ose of th eir US

cou n ter pa r ts in th e sa m e sector s. In 2 0 1 0, th ese com pa n ies h a d

v a lu a t ion s 3 8 per cen t , 5 8 per cen t , a n d 6 per cen t h ig h er th a n

th ose of th eir r espect iv e US cou n ter pa r ts.4

A down payment on growth

If cu r r en t v a lu a t ion lev els a r e ba sed in econ om ic r ea lity , w e

sh ou ld see ev iden ce to su ppor t th em —eith er som e in dica t ion th a t

oper a t in g per for m a n ce w ill im pr ov e sig n ifica n t ly in th e n ea r

fu tu r e or da ta su ppor t in g a n ex pecta t ion th a t g r ow th lev els w ill

con t in u e to ou tpa ce th ose of com pa n ies in dev eloped econ om ies.

Th e da ta a r e n ot con v in cin g on eith er poin t .

In fa ct , g iv en th e r ela t ion sh ip betw een g r ow th a n d P/E

m u lt iples, Ch in ese com pa n ies w ou ld n eed sig n ifica n t oper a t in g

im pr ov em en ts to ju st ify th e cu r r en t v a lu a t ion lev el (Ex h ibit 2 ).

Th eir r etu r n s on ca pita l h a v en ’t m a ter ia lly ch a n g ed in th e pa st

deca de (Ex h ibit 3 ), a n d v er y few sector s or com pa n y ty pes h a v e

ex per ien ced a m a jor im pr ov em en t in r etu r n s on ca pita l.5 Wh en

g oodw ill is in clu ded, th e r etu r n s of Ch in ese com pa n ies con tin u e

to la g beh in d th ose of th eir US a n d EU cou n ter pa r ts by a r ou n d 2

to 3 per cen t on a v er a g e—a bou t a s m u ch a s th ey h a v e for th e pa st

deca de. Wh en g oodw ill is ex clu ded, th e g a p r ises con sider a bly :

fr om 1 9 9 9 to 2 004 , th e r etu r n s on ca pita l of US com pa n ies w er e,

on a v er a g e, six per cen ta g e poin ts h ig h er . Sin ce th en , ou r

a n a ly sis fin ds th a t th e g a p h a s r isen to betw een 1 3 a n d 1 4

per cen t .6

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If v a lu a t ion lev els a r e n ot ba sed on im pr ov ed oper a t in g

per for m a n ce, th ey a r e, in effect , a dow n pa y m en t on ex pected

g r ow th . A n d it ’s tr u e th a t in th is r espect , Ch in ese com pa n ies

h a v e ou tper for m ed th eir cou n ter pa r ts in th e Un ited Sta tes a n d

Eu r ope for th e pa st few deca des. Yet sin ce th e cr isis, th er e h a s

been a g en er a l m oder a t ion in ex pecta t ion s for g r ow th in

cor por a te ea r n in g s a n d GDP in both th e Un ited Sta tes a n d Ch in a .

In fa ct , th e g a p betw een ex pected g r ow th in th e Un ited Sta tes

a n d Eu r ope a n d in Ch in a is a lm ost th e sa m e toda y a s it w a s

befor e th e r ecession . Th is fa ct sh ou ld com e a s n o su r pr ise.

Ch in ese com pa n ies w ill h a v e sig n ifica n t oppor tu n it ies to ex por t

to dev eloped m a r kets for y ea r s to com e; th e cr isis did n ot ch a n g e

th eir poten t ia l for g r ow th in dom est ic m a r kets; a n d m a n y of

th em a r e n ow pa st th e in it ia l sta g e of r a pid ex pa n sion . Ov er th e

sh or t ter m , du r in g th e n ex t few y ea r s, ex pected cor por a te

ea r n in g s g r ow th is a ctu a lly a bou t th e sa m e in Ch in a a s in th e

Un ited Sta tes a n d Eu r ope. In th e lon g er ter m , th e g a p betw een

for eca st US a n d Ch in ese g r ow th is n ot m u ch differ en t fr om

pr e-cr isis lev els.

Living up to expectations

It ’s possible th a t Ch in ese com pa n ies w ill m a ke g ood on th ese

h ig h er ex pecta t ion s. Cer ta in ly , it w ill h elp if th ey ca n deliv er

th e lev els of g r ow th th a t som e a n a ly sts for eca st . Bu t g r ow th

a lon e w on ’t be en ou g h ; com pa n ies w ill n eed to im pr ov e th eir

r etu r n s on ca pita l a s w ell.

Ch in ese m a n a g er s in ter ested in im pr ov in g th eir r etu r n s w ill, in

g en er a l, h a v e to be m or e disciplin ed in th in kin g a bou t h ow

effect iv ely th eir differ en t bu sin esses a n d g r ow th oppor tu n it ies

u se ca pita l. Th a t w on ’t be ea sy . A few com pa n ies a r e becom in g

m or e th ou g h tfu l a bou t th e w a y th ey pr ior it ize in v estm en ts a n d

a r e br in g in g g r ea ter disciplin e to decision m a kin g . Bu t w h en

ca pita l is fr eely a v a ila ble a n d th e size of a com pa n y deter m in es

th e per son a l im por ta n ce of its m a n a g er s—a s is th e ca se in

Ch in a —th e m otiv a t ion for disciplin e in th e u se of ca pita l is often

w ea k.

In v estor s a n d sta keh older s a lso h a v e a cr it ica l r ole to pla y . Th e

g ov er n m en t is a lr ea dy ex er t in g con sider a ble a dm in istr a t iv e

pr essu r e on sta te-ow n ed en ter pr ises to im pr ov e th eir ca pita l

efficien cy : on a v er a g e, th ese en ter pr ises la g sig n ifica n t ly beh in d

pr iv a te-sector on es in r etu r n s on ca pita l. Th e g ov er n m en t ca n

ex er t th is pr essu r e th r ou g h th e ba n kin g sy stem , w h ich r em a in s

th e pr in cipa l su pplier of ca pita l to th e Ch in ese econ om y , a n d a lso

th r ou g h th e Sta te Cou n cil’s Sta te-ow n ed A ssets Su per v ision a n d

A dm in istr a t ion Com m ission (SA SA C), th e a g en cy th a t

r epr esen ts th e g ov er n m en t a s sh a r eh older in th e sta te-ow n ed

com pa n ies. SA SA C h a s for sev er a l y ea r s been w or kin g a ct iv ely

w ith its por t folio com pa n ies to im pr ov e th eir disciplin e in u sin g

ca pita l. Pu blic-m a r ket sh a r eh older s ca n a lso pla y a h elpfu l r ole.

If th e im por ta n ce of a n issu e like in v estm en t disciplin e is

r eg u la r ly r ein for ced th r ou g h dia log u e w ith com pa n ies, it w ill

g r a du a lly m ov e u p th e m a n a g em en t a g en da .

Com pa n ies h opin g th a t str icter m a n a g em en t of th e cor por a te

por t folio w ill im pr ov e r etu r n s m ig h t a lso em ploy a tool

u n der u t ilized by ev en Wester n com pa n ies: div est itu r es a n d th e

r estr u ctu r in g of por t folios. Yet dom est ic M&A a ct iv ity in Ch in a is

ex tr em ely low by a n y m etr ic, a n d div est itu r es by con g lom er a tes

a r e ex tr em ely r a r e. Th er e is a poten t ia lly sig n ifica n t v a lu e

cr ea t ion oppor tu n ity h er e: div est itu r es cr ea te m or e v a lu e for th e

sellin g com pa n y ’s sh a r eh older s th a n for th e bu y er ’s,7 a n d seller s

a r e m or e likely to g et top dolla r if th ey div est w h ile a bu sin ess is

st ill str on g .8 Ou r per spect iv e is th a t sellin g n on cor e bu sin esses

isn ’t a m a r k of fa ilu r e or poor m a n a g em en t—it ’s a sig n th a t

m a n a g er s a r e a ct iv ely m a kin g a pr a ct ica l tr a de-off betw een

in cr ea sin g a com pa n y ’s size a n d m a n a g in g it m or e efficien t ly ,

w h ich is w h a t th e m a r kets a r e su g g est in g .

Th e Ch in ese g ov er n m en t is m in dfu l of th ese issu es, w h ich

u n der lie m u ch of th e SA SA C’s w or k to im pr ov e th e per for m a n ce

of sta te-ow n ed com pa n ies a s w ell a s th e pla n s to cr ea te a ct iv e

bon d a n d equ ity m a r kets, r edu cin g th e ba n kin g sy stem ’s r ole in

ca pita l in ter m edia t ion . Th e for m er cr ea tes pr essu r e th r ou g h

a dm in istr a t iv e m ea su r es to u se ca pita l m or e effect iv ely , a n d th e

la tter u ses m a r ket for ces to en cou r a g e a m or e efficien t a lloca t ion

of ca pita l a n d, by ex ten sion , to im pose g r ea ter disciplin e on

com pa n ies. Th is h a s been a n object iv e of th e Sta te Cou n cil sin ce

th e 1 1 th fiv e-y ea r pla n , in 2 006 , bu t ev en ts fr om 2 007 on w a r d

slow ed its pr og r ess. It ’s likely to be ba ck on th e a g en da in th e

1 2 th fiv e-y ea r pla n , a n d th e cu r r en t focu s on con tr ollin g

in fla t ion a n d dom est ic liqu idity is a lso r a isin g a w a r en ess th a t too

m u ch fr eely a v a ila ble ca pita l ca n h a v e u n plea sa n t side effects.

It ’s a cr it ica l m om en t for Ch in ese com pa n ies, w h ose v a lu a t ion s a r e

h ig h ev en a s m a n y r ea ch th e poin t w h er e g r ow th in ev ita bly slow s.

In v estor s a ppa r en t ly r em a in con fiden t th a t com pa n ies w ill be a ble

to r a ise th eir oper a t in g per for m a n ce, a t lea st for n ow .

About the AuthorsDavid Cogman is a partner in McKinsey’s Shanghai office, and Emma W ang is a consultant in the Hong Kongoffice.

The authors would like to thank Richard Dobbs and Guoqing Wu for their contributions to the development of thisarticle.

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Notes1 Trailing P/E multiples of all Hong Kong–listed mainland Chinese companies versus US and EU broad marketindexes, 2002–06 average.

2 Marc H. Goedhart, Timothy Koller, and Nicolas C. Leung, “The scrutable East,” mckinseyquarterly.com,November 2004.

3 Both regions experienced a similar fall in profits during the recession, as a drop in demand in the United States ledto a fall in exports in China.

4 Datastream and McKinsey analysis.

5 The notable exceptions are resource companies, but that arguably results from the rise in commodity prices.

6 US companies achieved higher returns on invested capital—that is, better operating performance for assets—butgave up most of that improvement in the prices they paid to acquire assets inorganically.

7 David Cogman and Carsten Buch Sivertsen, “A return to deal making in 2010,” mckinseyquarterly.com, January2011.

8 Lee Dranikoff, Timothy Koller, and Antoon Schneider, “Divesting proactively,” mckinseyquarterly.com, June 2002.

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