The equity premium puzzle: empirical evidence for the “Korea Discount”

Abstract

This study examines the cost of equity capital (COC) and the factors that influence the COC of listed Korean companies, and compares the COC of Korean companies with that of companies from 31 selected countries. The major research question is whether companies that are listed in an emerging market have a disadvantage as they are underpriced through a higher COC (as compared with companies that are traded in developed markets). Consistent with the “Korea Discount,” we find that the COC is significantly higher for Korean companies than for companies in other countries after controlling for other relevant factors. However, the “Korea Discount” has significantly eased in recent years.

Keywords:

• analysts’ forecasts
• cost of capital
• firm characteristics
• Korea Discount
• Korean stock market

JEL Codes:

• G00
• G18
• M20

Acknowledgements

Choi and Pae acknowledge the financial support provided by the KDI School of Public Policy and Management and Korea University, respectively. The authors appreciate the helpful comments from Peter Easton, Martina Sipkova, and seminar participants at the KDI School of Public Policy, as well as those from two anonymous referees.

Notes

1. Estimates of the cost of capital are implied by market prices, analysts’ forecasts of earnings, and accounting numbers. Despite not being exactly identical, the terms, ‘implied cost of capital’ and ‘expected rate of return,’ are often used as equivalent to the cost of equity capital. They are the same only if we assume efficient market prices, and unbiased accounting numbers and analysts’ forecasts.

2. Ramstad (2007b) noted: “… Even after South Korea met developed-market income qualifications in 2003, the firms that create indexes expressed concerns from market volatility to weak dividend payouts to the risk of trouble from neighboring North Korea … An upgrade in market status has become a major goal for some government officials and news media in South Korea, where rankings and comparisons with other countries are taken very seriously. After FTSE and MSCI criticized the low level of dividends paid by South Korean companies, the government, which owns the Korean stock xchange, in 2004 encouraged companies to change by creating an index of the top 50 companies based on dividends.”

3. Knowing the weakness of the P/E ratio, market practitioners frequently use other arguable heuristics such as the price-to-sales (P/S) or the PEG ratio (Bradshaw 2002, Fisher 2007). Nevertheless, even these ratios are still significantly affected by other economic factors (Easton 2004).

4. E.g. the expected inflation rate: risk-free rate –3%.

5. One line of reasoning is that the Korean financial system has shortcomings such as: (1) volatility of the Korean stock market due to investors’ characteristics regarding short-term speculation (Chang 2005); (2) restrictions on the stock market (e.g. restricted short-selling); and (3) general weakness of financial systems (e.g. insufficient shareholder protection, restrictions on hedge or pension funds, etc.). Besides, various serious discount factors represented by: (1) poor corporate governance (Baek et al. 2004, Hail and Leuz 2006, Baek et al. 2009); (2) lack of business ethics, including corporate transparency (Baek et al. 2004, Choi and Jung 2008, Choi and Nakano 2008); (3) inadequate and less timely disclosure (Botosan 1997, Botosan and Plumlee 2002, Poshakwale and Courtis 2005, Dargenidou et al. 2006, Habib 2006, Lambert et al. 2007); (4) militant labor unions (Seggerman 2007); and (5) low national brand value have also been provided by business corporations. Concerning the undervaluation of Korea, Kim (2008) reports: “According to the 2007 Anholt-GMI Nation Brands Index, Korea ranked 32nd out of 38 countries worldwide in terms of national brand. Korea’s national brand value accounts for merely 29% of its gross domestic product, which is paltry compared with 224% for Japan and 143% for the USA. What is worse, Korea lags behind countries with smaller economies, like Mexico, Poland and Egypt, in terms of national brand value. For that reason, Korean products are more than 30% cheaper than similar quality products from Germany and Japan in international markets.”

6. The COC was also estimated by using different models including the modified PEG ratio model (O’Hanlon and Steele 2000, Gebhardt et al. 2001, Easton et al. 2002, Easton 2004). Implied by the prior discussion, regarding the validity of COC, the mean (median) value of COC estimated by alternative models was used as a proxy for the cost of capital (Hail and Leuz 2006) in addition to individual estimates. The correlation between the COCs that were estimated by alternative models was very high and the results were qualitatively similar.

7. We also estimated the COC from a PEG model (Easton 2004) as follows: . The result was not sensitive to the choice of the estimation method.

8. For example, when Hail and Leuz (2006) estimated the COC by using four different models, they found that the choice of model did not have a significant impact on the results.

9. Annual inflation rate (Nissim and Penman 2003).

10. We also used the GDP growth rate as well as the GDP without the natural log operator. The results were qualitatively identical.

11. www.transparency.org.

12. www.worldbank.org.

13. We also used firm-level measures for the quality of accruals. The result was qualitatively similar.

14. The archival database for earnings forecasts for Korean companies was available from 2000.

15. As of 31 December 2007, 745 companies were listed on the Korean stock exchange and 1026 companies were listed on the KOSDAQ exchange.

16. DataGuide Pro, which is a financial database prepared and maintained by FnGuide, Inc., provides companies’ financial data, analysts’ reports, and economic data. TS2000 and KSRI were also used as alternative sources of financial data. The results were qualitatively similar. TS2000 is a database that provides companies’ financial data; it is prepared and maintained by the Korea Listed Companies Association. The KSRI Stock Database is provided by the Korea Securities Research Institute.

17. We use financial data from DataGuide Pro as this database contains a complete dataset for Korean companies; I/B/E/S reports substantially fewer observations.

18. www.transparency.org.

19. Gebhardt et al. (2001) report that P/B is the most important variable in explaining the variation in the implied costs of capital.

20. Alternative financial measures including market capitalization were also tested as proxy variables.

21. Fama and French (1997, 2002) conclude that the cost of capital estimated from historic beta is unavoidably imprecise.

22. We report the COC as estimated by the OJ model since the data used by this model are more easily available; thus, we were able to obtain more observations. We speculate that the implications of an analysis based on the estimates obtained by the model of Easton et al. (2002) will be qualitatively similar as prior literature has reported a very high correlation between the costs of capital that are legitimated by these two methods (e.g. Daske 2006).

23. We performed the analysis with various control variables such as the market beta, total assets, and ROE. The implication of the result was not sensitive to the choice of control variables.

24. The analysis was also conducted with the P/B ratio. The result was qualitatively similar.

25. For example, by 2007, Korea had slipped for three consecutive years in terms of FDI and ranked 60th globally.