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

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

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

Valuation Drivers

Very High Stock Market Volatility Source: UBS Warburg

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

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

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

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.

Dividend Discount Valuation: High implied Risk Premium

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

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