Have Investors Got Chinese Companies’ Capital Efficiency Wrong?

Shares in publicly listed Chinese companies used to sell at a discount to their peers in developed markets. Now they sell at a premium. David Cogman and Emma Wang of McKinsey & Co., the international management consultancy, writing in the McKinsey Quarterly, ask whether this is because the companies have changed or just investors’ perceptions of them.

Their answer leans towards the latter, but largely, they say, because investors have expectations of faster growth in emerging economies than in developed ones. Cogman and Wang think investors may be taking a too rosy a view about how that will flow back to corporate profits growth and share prices. “Given the relationship between growth and P/E multiples, Chinese companies would need significant operating improvements to justify the current valuation level,” they say.

If investors’ expectations are to be met, then there will have to be a narrowing of the underlying cause of the valuation disparity, return on capital (on average, the authors find for 2006-10, six percentage points lower than that of comparable U.S. companies). This is a straw best grasped by long-term investors, though the authors point out that more efficient use of capital is back on the agenda with the new five-year plan. This includes administrative measures to get the giant state-owned enterprises to use the capital they get through the banking system more effectively, for example, though divestitures and other M&A to restructure (the authors are from McKinsey’s corporate finance practice, after all), and the expansion of equity and bond markets to use market forces to encourage a more efficient allocation of capital and, by extension, to impose greater discipline on companies.

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