1. Does it exist? Is it justified?
Korea Discount:
Does it exist? Is it justified?
June 21, 2002
Dr. Eugen Loeffler

2. Korea Discount What is it?
Valuation discount for Korean stocks compared to US/mature market stocks because of Korean companies’
Higher risk
Lower transparency
Inadequate corporate governance
How is it measured?
Comparison of PE / Price Book valuation ratios
Does it exist / is it justified?
“Dirty” measurement / simplistic assessment
Assessment of valuation drivers / Dividend discount valuation

3. Korea Discount: Measured by PER
Caveat
PE is too simplistic a measure not taking into account significant differences between national stock markets

4. Valuation Drivers

5. Very High Stock Market Volatility
Source: UBS Warburg

6. Short History of Positive Free Cash Flow
Unit: billion KRW
Source: Wisefn, All Manufacturing Companies (total 630)

7. Empirical Evidence for Inefficiency of Korean Corporations
Korean corporate sector data (H1 2001)
One out of 4 Korean manufacturing companies reported to be in the red
One out of 5 KSE listed companies in state of capital erosion
30% of listed companies have interest coverage ratio below 1
Bain & Company Analysis
Only 6% of large Korean companies (sales > 1 trn Won) are sustainable value creators vs. 13% globally
Criteria: Real 10 year sales and earnings growth > 5.5% / Total return to stock investor > cost of equity capital
Boston Consulting Group Analysis
200 largest Korean companies in 2000 (GDP growth of 8%!) on average failed to earn their cost of capital
Total collective economic loss = 5.5 trn Won
Methodology: Cash Flow Return on Investment (CFROI) vs. cost of capital
Korean companies’ CFROI = 6.3% vs. 9.8% for leading global companies

8. Intransparancy / Opacity
Opacity Index by PriceWaterhouseCoopers (PWC)
“Opacity is the lack of clear, accurate, formal, easily discernible, and widely accepted practices in the world’s capital markets” (PWC)
5 principal areas of opacity according to PWC
Corrupt practices in government bureaucracy allowing bribery or favoritism
Unclear, conflicting or incomplete laws governing property rights
Vague or unpredictably changing economic policies
Weak, inconsistent or unenforced accounting standards
Unclear, inconsistent, irregularly applied business regulations
CLEAR = Corruption, Legal, Economic, Accounting, Regulatory

9. Scores for Opacity-Factors and Components
These data are based on average survey responses for the five types of opacity. Using the simple averages derived from aggregating the survey responses, we derive the O-Factor by adjusting the scores so that larger scores reflect more opacity, while smaller scores reflect more transparency.

10. Dividend Discount Valuation: High implied Risk Premium

11. Remedies: What the Government Can Do
Expose companies to the forces of a competitive market
Stop government interference in industry structures
Deregulate economy and stop preferential or discriminating treatment of companies
Remove all direct and indirect barriers to foreign competition
No direct/indirect government led support to ailing companies
Provide legal and regulatory framework promoting adequate transparency and corporate governance
Strict enforcement of accounting rules
Strict enforcement of corporate laws (esp. regarding influence of major shareholders)
Promote free market of corporate control
Hostile takeovers, proxy contests
Institutionalization of capital markets with independent institutional investors under pressure to perform

12. Remedies: What Companies Can Do
Prune non-performing business activities
Closure, sale of money-losing businesses
Restructuring of businesses with returns below cost of capital
Focus on core competencies
Only compete in business with sustainable competitive advantage
Only industry leading positions (Top 3-5 domestic, globally)
Shareholder value focus
“True” shareholder representatives in board
Align management incentives with shareholder interests (management compensation)
Transparent commitment to company goals: return targets supported by internal controlling system (EVA etc.)
Promote transparency: company strategy, accounting, information policy