Following the economic crisis and recession, valuations in China are 20 to 30 percent higher than in the US and the EU. This is a reversal, as traditionally emerging markets trade 20 to 30 percent below developed markets. So why the shift from West to East? The McKinsey Quarterly’s David Cogman and Emma Wang note that in 2008 and 2009, this shift in valuations would be understandable and could have been explained as a “temporary, liquidity-fueled anomaly.”
Two to three years later, China’s valuations are still at levels that are significantly higher than the US and the EU. Cogman and Wang ask what such trading can mean. They give two possibilities: first, Chinese companies improved during the recession or second, investors are assuming future economic improvement in the emerging market. Cogman and Wang say that data backs up the second hypothesis.
It remains to be seen, however, if China will live up to its investors’ expectations. The authors indicate that despite current valuations, the average return on equity for Chinese companies is 6% below that of US companies (even when US companies were losing profitability, this was the case). This indicates a price-earnings (P/E) ratio multiple 20 percent below that of the US, assuming Chinese industry was stagnant, or a P/E ratio 10 to 15 percent below that of the US if Chinese companies were growing 3 to 5 percent.
So, this means investors expect an improved performance from Chinese companies (this is the only way to rationalize such high valuation numbers). Such improvement, however, would require Chinese companies to realize a significant increase in returns on capital — something that may be difficult to do. Cogman and Wang note that widely available capital can discourage motivation to invest wisely, and make this increase in return on capital difficult.
CEOs should consider all of these issues when determining whether to invest capital in China. These skeptical statistics may also be important when assessing your competition. It’s hard to tell what path these emerging markets will take, but as Cogman and Wang conclude, “The current focus on controlling inflation and domestic liquidity is also raising awareness that too much freely available capital can have unpleasant side effects.”