How expensive is China now? Comparing business valuation metrics in China with other markets.
Chinese equity markets have been among the worst performing globally in 20118. China’s economy has slowed sharply in recent months, feeling the effects of trade tensions with the US and government attempt to curb debt levels. Macroeconomic uncertainties have hit financial markets: the Shanghai composite ended the year 2018 24,6% lower than its final close of 2017, while the Shenzhen composite plummeted about 33,2%.
What is the impact on business valuation in China? Have the stock prices overshot in such a way that China is now an attractive market to invest?
Like every year, NYU Professor Aswath Damodaran published in January an interesting set of financial data and market multiples allowing country comparison. These data, updated on January 1st, can be found on his personal website.
PE ratio in China vs advanced economies and India
The price earnings ratio, for all its volatility and measurement weaknesses, remains among the most widely used tools in investing. PE ratios can be compared across countries, to identify relative “cheapness”. Pr. Damodaran’s data sets show several series of PE ratio. To get the most representative results, it is better to consider the PE ratios based on aggregate values for market capitalization and net income. Indeed, a mere comparison of average ratios might be distorted by some companies with negative earnings, or with very low earnings pulling ratios to high and meaningless value. Like Pr. Damodaran says, the aggregate value is not as sensitive to outliers and reflects more closely a weighted average of companies in the market, with values representing the weights.
The data shows that China aggregate PE ratio is, at 11.20x in the beginning of the year, the lowest compared with US, Europe, Japan and India. It is a little lower the aggregate ration computed globally. It is worth emphasizing that Europe and Japan, as well as China, are lagging behind the US with a high 16.05x ratio. Is this finding, based on gross multiples, enough to consider China a cheap market? We need to use more finesse and look how prices reflect expected return and risk.
Is China really a cheap market?
In fact, one could expect a cheap market would offer a combination of a low PE and high earnings growth or low risk. An expensive market would be one with high PE and low earnings growth or high risk. Indeed, high price should reflect either high returns or low risk. To look for mismatches, we can look at some other country dataset published by Pr. Adomaran: equity risk premiums as well as expected growth of earnings per share.
It can be noted that China market risk, as measured by the equity risk premium (ERP), is low compared with other countries or regions. It is the same than Japan, and is slightly lower than Europe while higher than US. It is quite lower than a large emerging market like India. It is true that the sovereign credit default swap is a major component in the computation of the ERP. The Chinese government does not issue external debt and enjoys a very comfortable amount of more than US$ 3 trillion foreign exchange reserves. Sovereign risk is then generally considered as very low, which may distort the assessment of stock market risk. However, one has also to keep in mind that, as it happened in 2015, when needed to preserve financial stability, the Chinese government may not hesitate to transfer risk from the market to the public sector. It can do so because it firmly controls the financial sector and because the size of financial markets in China are still limited when compared to the size of GDP. So yes, under these circumstances, Chinese asset prices may look relatively cheap, with a low PE for a low market risk.
When we look at expected earnings growth for the net 5 years, we can draw similar conclusions. Indeed, expected growth in China is still quite high (22,2%) compared with advanced economies (11,6-14,4%) and is rather similar to India. This is in line with the previous conclusion: China looks cheap too when considering expected earnings growth.
How much is your business worth in China?
Those who have started a business in China or who have invested in China would probably like to have more insight about the value of their business. First it is interesting to note that the ranking of industries according to their aggregate PE is more or less the same across countries. In China, industries with the lowest PE ration (4 to 6x) are construction and financial services. Those which are the priciest are biotechnologies, software and healthcare (25 to 35x). Same findings can be generally observed in US and Europe, though with some slight variations and higher multiples for the cheapest industry.
Professor Damodaran also gives us the aggregate multiples for China most widely used by investors.
Obviously, these multiples can vary considerably by industry. We can detail these in industries where European investors have expanded in China in the past years. Today it appears that among these industries, automotive is not doing so well in China, and apparel may look a bit disappointing. However, healthcare and e-commerce are valued a high price both by all ratios. Restaurant and dining show high PE and P/S multiples. Environmental and renewable energy industries show high P/S ratios but more normalized earnings ratios, reflecting high margins.
These metrics only give a rough ideas of market prices in China in the beginning of the year 2019. Of course, it goes without saying that to properly value a business or to make investment decisions, one needs to look much more into details the business plan, do market analysis and use a tailor-made methodology. However some readers might find these datasets provide interesting insights about the Chinese market.