Korea discount: Diagnosis and remedy

Abstract

Korea discount refers to the phenomenon that Korean firms are valued lower than firms in other countries. In spite of large media and public attention to this issue, there is a paucity of academic studies that systematically examine the extent and cause of the low valuation of Korean firms. Using firm-level data from seventeen countries over the period 2000 similar to 2004, we address these issues. Specifically, we examine the extent to which the valuation of Korean firms is low relative to comparable firms in other countries. We then explore several potential explanations for the low valuation of Korean firms. Our research design departs from several prior studies on the topic of low valuation of Korean firms. First, in evaluating the extent of low valuation of Korean firms, we use extensive firm-level data around the world. Our sample includes firms from seventeen countries comprised of developing as well as major countries. Second, we use a valuation measure, the price-to-cash flow ratio (P/CF), which is impervious to distortions arising from different accounting systems across countries-that is, unlike the price-to-earnings ratio (P/E) and the price-to-book ratio (P/B) that are known to be affected substantially by different accounting systems. Third, we make "apples-to-apples" comparisons in firm value between Korean and comparable foreign firms. Instead of comparing the value of representative (e.g., large cap) Korean and foreign firms that may be widely different in firm characteristics, we use discriminant analysis to select matching foreign firms in each foreign country that are similar to Korean sample firms in firm size, profitability, growth, and stock price volatility. Finally, we go beyond merely documenting the extent of low valuation of Korean firms and explore potential explanations for the low valuation. Our sample covers the period 2000 similar to 2004. Each year's sample is constructed in the following manner. We first choose fifty largest firms (in terms of the year-end market capitalization) in Korea among the firms covered by the Worldscope database. We then choose a matching sample of fifty firms in each of the sixteen countries using the discriminant analysis. These matching firms are selected so that they are similar to the Korean sample firms in firm size, profitability, growth, and stock price volatility. Our empirical analysis conducts several tests including Wilcox tests and multiple regressions. We find that almost invariably across country pairs and across years, the value of Korean firms is significantly lower than not just firms from major countries but those from developing countries. Thus, our results suggest that the low valuation of Korean firms is substantial. And the results are particularly surprising because the value of Korean firms is low even relative to firms in many Asian developing countries that are in similar or relatively early stages of stock market development. We then discuss and explore several potential explanations for the low valuation of Korean firms. More than anything, our empirical results cast doubt on the corporate governance argument on "Korea discount"-which holds that the poor governance structure of Korean firms is the major reason for the low valuation of Korean firms. This explanation is inadequate because the poor-governance argument is not able to explain the finding that the value of Korean firms is lower than the value of firms in many developing countries whose corporate governance is even less advanced than that of Korean firms. Through additional empirical investigations, we examine whether the low valuation of Korean firms may be related to investor characteristics in the Korean stock market. Our results show that the tendency for Korean investors to engage in short-term speculations is very strong. Among the seventeen sample countries, the Korean stock market ranks first or second in the stock price volatility as well as market turnover. Moreover, we find that earnings of Korean firms display poor relevance to stock prices: the value relevance of the Korean stock market ranks last among the seventeen sample countries. Thus, the strength of link between fundamentals and stock prices is extremely low in Korea. Overall, our investigations indicate that the Korean stock market is dominated by short-term speculators whose buy and sell decisions are not necessarily tied to business fundamentals. Based on these observations, we propose that the prevalence of short-term speculation in the Korean stock market may be the cause of substantial deviation of the value of Korean firms from the value of comparable firms in other stock markets. Especially, investors in the Korean stock market do not rely on the popular valuation metrics such as P/CF, P/E and P/B for investment decisions because those metrics are useful mainly for longterm investing based on business fundamentals. This can create large deviations of the value of Korean firms from comparable foreign firms in terms of these valuation metrics. In concluding, we argue that the low valuation in the Korean stock market may be remedied with the promotion of long-term investment culture.