Can Chinese Companies Live Up To Investor Expectations

Can Chinese companies live up to
investor expectations?
In a reversal of long-term trends, Chinese com panies now enjoy a
valuation prem ium over their peers in developed m arkets. Whats
changed?
May 2011 David Cogman and Emma Wang
Source: Corporate Finance Practice
A r e Ch i n ese a n d ot h er com pa n ies in em er g in g m a r k et s fin a lly

g et t in g t h e r espect t h ey deser v e? Hist or ica lly , t h ey v e t r a ded a t
a discou n t on a ll m et r ics of v a lu a t ion t y pica lly , in t h e r a n g e of
2 0 t o 3 0 per cen t . 1 Ev en a s t h e u n der ly in g Ch in ese econ om y
dev eloped a n d t h e sh a r es of t h ese com pa n ies beca m e a
com m on ly a ccept ed in v est m en t opt ion , n eit h er in st it u t ion a l n or
r et a il in v est or s qu it e sh ook t h e per cept ion t h a t su ch secu r it ies
w er e g en er a lly r isk y . Y et if t h e A sia n fin a n cia l cr isis of t h e la t e
1 9 9 0 s r ein for ced t h a t belief, t h e cr edit cr isis of 2 0 0 7 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 k et s n ow t r a de a t a pr em iu m t o t h eir peer s in dev eloped
m a r k et s.
It s t r u e t h a t in t h e w a k e of t h e cr isis a n d t h e en su in g r ecession ,
in v est or s h a v e t a k en n ot e of t h e g r ea t r eba la n cin g of econ om ic
pow er , sh ift in g fr om W est t o Ea st , a n d h a v e r et h ou g h t lon g -h eld
beliefs a bou t t h e r ela t iv e secu r it y of a sset cla sses in bot h
dev eloped a n d dev elopin g econ om ies. Bu t a n im por t a 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 k et s ch a n g ed or ju st
in v est or s per cept ion s of t h em ? T h e qu est ion is a pt in a n u m ber
of em er g in g m a r k et s, 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 t h e r ev er sa l in pr em iu m s is
m ost n ot icea ble. If t h ese v a lu a t ion s r eflect in v est or s
ex pect a t ion s for fu t u r e g r ow t h a n d r et u r n s, a r e t h er e v a lid
r ea son s t o believ e t h a t t h ose of Ch in ese com pa n ies h a v e
im pr ov ed t h r ou g h t h e r ecession ? Or a r e in v est or 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 t a
su g g est t h e la t t er .
A shift in valuation
In em er g in g m a r k et s, t h e h ist or ica l discou n t of com pa n ies w a s
g en er a lly in lin e w it h t h 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 ket s m a y t y pica lly h a v e ex h ibit ed
h ig h er g r ow t h bu t a lso h a d m u ch low er r et u r n s on ca pit a l t h a n
t h eir W est er n peer s. T h is differ en ce a lm ost com plet ely ex pla in s
t h e differ en ce in v a lu a t ion m u lt iples. Fr om 2 0 0 6 t o 2 0 1 0 , ou r
a n a ly sis fou n d t h e a v er a g e r et u r n on equ it y (ROE) of Ch in ese
com pa n ies t o be six per cen t a g e poin t s below t h a t of US
com pa n iesa g a p t h a t r em a in ed ev en w h en t h e pr ofit a bilit y of
US com pa n ies fell. 3 T h 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 t h ese
m a r k et s h a d been g r ow in g t h r ee t o fiv e per cen t a g e poin t s fa st er ,
t h eir low er r et u r n s on ca pit a l st ill w a r r a n t ed a P/E discou n t of
1 0 t o 1 5 per cen t r ela t iv e t o t h eir dev eloped-m a r k et
cou n t er pa r t s. T h is discou n t h a s r ev er sed in som e m a r k et s in t h e
w a k e of t h e econ om ic cr isis. Com pa n ies in Ch in a , a lon g w it h
t h ose in In dia a n d La t in A m er ica , n ow t r a de a t a pr em iu m t o
com pa n ies in dev eloped m a r k et s (Ex h ibit 1 ).
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In 2 0 0 8 0 9 , it w a s qu it e ea sy t o w r it e t h is dev elopm en t off a s a

t em por a r y , liqu idit y -fu eled a n om a ly . In v est or s w a n t ed t o be
a n y w h er e bu t dev eloped m a r k et s. W h ile com pa n ies in
dev elopin g on es st ill h a d less t r a n spa r en t fin a n cia l r epor t in g a n d
w ea k er g ov er n a n ce, t h ey g en er a lly h a d less r isk y ba n k in g
sy st em s a s a r esu lt of st r on g er g ov er n m en t con t r ols. A lso,
g ov er n m en t s didn t h a v e t o pr op u p in du st r ia l com pa n ies, a s t h e
Un it ed St a t es did in t h e a u t om ot iv e sect or . Som e m a jor
em er g in g m a r k et s, w it h t h eir pr om ise of h ig h g r ow t h a n d low er
cost ba ses, w er e per ceiv ed a s sa fer t h a n dev eloped m a r k et s
t h ou g h n ot a ll em er g in g m a r k et s w er e equ a lly fa v or ed. On ly
Ch in a a n d In dia a ch iev ed t h e v a lu a t ion pr em iu m for a

pr ot r a ct ed per iod; com pa n ies in Br a zil a n d Ru ssia t r a ded a t a
discou n t t o t h ose in dev eloped m a r k et s t h r ou g h ou t t h e r ecession .
In Ch in a , t h e sh ift in v a lu a t ion s h a s n ot pr ov ed t o be a n
a n om a ly . T h ey r em a in a t a 2 0 t o 3 0 per cen t pr em iu m a bov e
t h ose in t h e Un it ed St a t es a n d t h e Eu r opea n Un ion a n d t h e g a p
is n ot ex pla in ed by a differ en t in du st r ia l st r u ct u r e. On a n
in du st r y -by -in du st r y ba sis, t h e g a p is ev en la r g er . In 2 0 0 8 , P/E
r a t ios for Ch in ese com pa n ies in t h e in du st r ia l, con su m er g oods,
a n d fin a n cia l sect or 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 , t h a n t h ose of t h eir US
cou n t er pa r t s in t h e sa m e sect or s. In 2 0 1 0 , t h 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 t h a n
t h ose of t h eir r espect iv e US cou n t er pa r t s. 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 lit y , w e
sh ou ld see ev iden ce t o su ppor t t h em eit h er som e in dica t ion t h 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 t h e n ea r
fu t u r e or da t a su ppor t in g a n ex pect a t ion t h a t g r ow t h lev els w ill
con t in u e t o ou t pa ce t h ose of com pa n ies in dev eloped econ om ies.
T h e da t a a r e n ot con v in cin g on eit h er poin t .
In fa ct , g iv en t h e r ela t ion sh ip bet w een g r ow t h 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 t s t o ju st ify t h e cu r r en t v a lu a t ion lev el (Ex h ibit 2 ).
T h eir r et u r n s on ca pit a l h a v en t m a t er ia lly ch a n g ed in t h e pa st
deca de (Ex h ibit 3 ), a n d v er y few sect or s or com pa n y t y pes h a v e
ex per ien ced a m a jor im pr ov em en t in r et u r n s on ca pit a l. 5 W h en
g oodw ill is in clu ded, t h e r et u r n s of Ch in ese com pa n ies con t in u e
t o la g beh in d t h ose of t h eir US a n d EU cou n t er pa r t s by a r ou n d 2
t o 3 per cen t on a v er a g ea bou t a s m u ch a s t h ey h a v e for t h e pa st
deca de. W h en g oodw ill is ex clu ded, t h e g a p r ises con sider a bly :
fr om 1 9 9 9 t o 2 0 0 4 , t h e r et u r n s on ca pit a l of US com pa n ies w er e,
on a v er a g e, six per c en t a g e poin t s h ig h er . Sin ce t h en , ou r
a n a ly sis fin ds t h a t t h e g a p h a s r isen t o bet w 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, t h ey a r e, in effect , a dow n pa y m en t on ex pect ed
g r ow t h . A n d it s t r u e t h a t in t h is r espect , Ch in ese com pa n ies
h a v e ou t per for m ed t h eir cou n t er pa r t s in t h e Un it ed St a t es a n d
Eu r ope for t h e pa st few deca des. Y et sin ce t h e cr isis, t h er e h a s
been a g en er a l m oder a t ion in ex pect a t ion s for g r ow t h in
cor por a t e ea r n in g s a n d GDP in bot h t h e Un it ed St a t es a n d Ch in a .
In fa ct , t h e g a p bet w een ex pect ed g r ow t h in t h e Un it ed St a t es
a n d Eu r ope a n d in Ch in a is a lm ost t h e sa m e t oda y a s it w a s

befor e t h e r ecession . T h 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 t u n it ies t o ex por t
t o dev eloped m a r k et s for y ea r s t o com e; t h e cr isis did n ot ch a n g e
t h eir pot en t ia l for g r ow t h in dom est ic m a r k et s; a n d m a n y of
t h em a r e n ow pa st t h e in it ia l st a g e of r a pid ex pa n sion . Ov er t h e
sh or t t er m , du r in g t h e n ex t few y ea r s, ex pect ed cor por a t e
ea r n in g s g r ow t h is a ct u a lly a bou t t h e sa m e in Ch in a a s in t h e
Un it ed St a t es a n d Eu r ope. In t h e lon g er t er m , t h e g a p bet w een
for eca st US a n d Ch in ese g r ow t h is n ot m u ch differ en t fr om
pr e-cr isis lev els.
Living up to expectations
It s possible t h a t Ch in ese com pa n ies w ill m a k e g ood on t h ese
h ig h er ex pect a t ion s. Cer t a in ly , it w ill h elp if t h ey ca n deliv er
t h e lev els of g r ow t h t h a t som e a n a ly st s for eca st . Bu t g r ow t h
a lon e w on t be en ou g h ; com pa n ies w ill n eed t o im pr ov e t h eir
r et u r n s on ca pit a l a s w ell.
Ch in ese m a n a g er s in t er est ed in im pr ov in g t h eir r et u r n s w ill, in
g en er a l, h a v e t o be m or e disciplin ed in t h in k in g a bou t h ow
effect iv ely t h eir differ en t bu sin esses a n d g r ow t h oppor t u n it ies
u se ca pit a l. T h a t w on t be ea sy . A few com pa n ies a r e becom in g
m or e t h ou g h t fu l a bou t t h e w a y t h ey pr ior it ize in v est m en t s a n d
a r e br in g in g g r ea t er disciplin e t o decision m a k in g . Bu t w h en
ca pit a l is fr eely a v a ila ble a n d t h e size of a com pa n y det er m in es
t h e per son a l im por t a n ce of it s m a n a g er sa s is t h e ca se in
Ch in a t h e m ot iv a t ion for disciplin e in t h e u se of ca pit a l is oft en
w ea k .
In v est or s a n d st a k eh older s a lso h a v e a cr it ica l r ole t o pla y . T h 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 ist r a t iv e
pr essu r e on st a t e-ow n ed en t er pr ises t o im pr ov e t h eir ca pit a l
efficien cy : on a v er a g e, t h ese en t er pr ises la g sig n ifica n t ly beh in d
pr iv a t e-sect or on es in r et u r n s on ca pit a l. T h e g ov er n m en t ca n
ex er t t h is pr essu r e t h r ou g h t h e ba n k in g sy st em , w h ich r em a in s
t h e pr in cipa l su pplier of ca pit a l t o t h e Ch in ese econ om y , a n d a lso
t h r ou g h t h e St a t e Cou n cils St a t e-ow n ed A sset s Su per v ision a n d
A dm in ist r a t ion Com m ission (SA SA C), t h e a g en cy t h a t
r epr esen t s t h e g ov er n m en t a s sh a r eh older in t h e st a t e-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 k in g a ct iv ely
w it h it s por t folio com pa n ies t o im pr ov e t h eir disciplin e in u sin g
ca pit a l. Pu blic-m a r k et sh a r eh older s ca n a lso pla y a h elpfu l r ole.
If t h e im por t a n ce of a n issu e lik e in v est m en t disciplin e is
r eg u la r ly r ein for ced t h r ou g h dia log u e w it h com pa n ies, it w ill
g r a du a lly m ov e u p t h e m a n a g em en t a g en da .
Com pa n ies h opin g t h a t st r ict er m a n a g em en t of t h e cor por a t e
por t folio w ill im pr ov e r et u r n s m ig h t a lso em ploy a t ool
u n der u t ilized by ev en W est er n com pa n ies: div est it u r es a n d t h e
r est r u ct u r in g of por t folios. Y et dom est ic M&A a ct iv it y in Ch in a is
ex t r em ely low by a n y m et r ic, a n d div est it u r es by con g lom er a t es
a r e ex t r em ely r a r e. T h er e is a pot en t ia lly sig n ifica n t v a lu e
cr ea t ion oppor t u n it y h er e: div est it u r es cr ea t e m or e v a lu e for t h e
sellin g com pa n y s sh a r eh older s t h a n for t h e bu y er s, 7 a n d seller s
a r e m or e lik ely t o g et t op dolla r if t h ey div est w h ile a bu sin ess is
st ill st r on g . 8 Ou r per spect iv e is t h 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 t h 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 t r a de-off bet w 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 t h e m a r k et s a r e su g g est in g .
T h e Ch in ese g ov er n m en t is m in dfu l of t h ese issu es, w h ich
u n der lie m u ch of t h e SA SA Cs w or k t o im pr ov e t h e per for m a n ce
of st a t e-ow n ed com pa n ies a s w ell a s t h e pla n s t o cr ea t e a ct iv e
bon d a n d equ it y m a r k et s, r edu cin g t h e ba n k in g sy st em s r ole in
ca pit a l in t er m edia t ion . T h e for m er cr ea t es pr essu r e t h r ou g h
a dm in ist r a t iv e m ea su r es t o u se ca pit a l m or e effect iv ely , a n d t h e
la t t er u ses m a r ket for ces t o en cou r a g e a m or e efficien t a lloca t ion
of ca pit a l a n d, by ex t en sion , t o im pose g r ea t er disciplin e on
com pa n ies. T h is h a s been a n object iv e of t h e St a t e Cou n cil sin ce
t h e 1 1 t h fiv e-y ea r pla n , in 2 0 0 6 , bu t ev en t s fr om 2 0 0 7 on w a r d
slow ed it s pr og r ess. It s likely t o be ba ck on t h e a g en da in t h e
1 2 t h fiv e-y ea r pla n , a n d t h e cu r r en t focu s on con t r ollin g
in fla t ion a n d dom est ic liqu idit y is a lso r a isin g a w a r en ess t h a t t oo
m u ch fr eely a v a ila ble ca pit a l ca n h a v e u n plea sa n t side effect s.
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 t h e poin t w h er e g r ow t h in ev it a bly slow s.
In v est or s a ppa r en t ly r em a in con fiden t t h a t com pa n ies w ill be a ble
t o r a ise t h eir oper a t in g per for m a n ce, a t lea st for n ow .
About the Authors

David Cogman is a partner in McKinseys Shanghai office, and Emma W ang is a consultant in the Hong Kong
office.
The authors would like to thank Richard Dobbs and Guoqing Wu for their contributions to the development of this
article.
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Notes
1 Trailing P/E multiples of all Hong Konglisted mainland Chinese companies versus US and EU broad market
indexes, 200206 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 led
to 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 capitalthat is, better operating performance for assetsbut
gave 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, January
2011.
8 Lee Dranikoff, Timothy Koller, and Antoon Schneider, Divesting proactively, mckinseyquarterly.com, June 2002.
Copyright 1992-2011 McKinsey & Company

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Can Chinese companies live up to

A r e Ch i n ese a n d ot h er com pa n ies in em er g in g m a r k et s fin a lly

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

In 2 0 0 8 0 9 , it w a s qu it e ea sy t o w r it e t h is dev elopm en t off a s a

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

A down payment on growth

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

a n d Eu r ope a n d in Ch in a is a lm ost t h e sa m e t oda y a s it w a s

About the Authors

Copyright 1992-2011 McKinsey & Company

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