Understanding Cross-Country Differences in Valuation Ratios: A Variance Decomposition Approach
41 Pages Posted: 16 Sep 2011 Last revised: 26 Jun 2014
Date Written: June 5, 2014
We use a variance decomposition approach to examine why aggregate valuation ratios differ across countries. In a cross section of 22 developed countries from 1980 to 2009, we find that 50% of all cross-country differences in the aggregate price-to-book ratio (P/B) can be explained by cross-country differences in expected future five-year profitability. In the second half of our sample period, this percentage exceeds that of the first half, rising to almost 64%. Although international differences in accounting standards and conventions may have made earnings from different countries more difficult to compare relative to dividends, we find that it is still cross-country differences in expected future profitability, rather than dividend growth rates, that are more closely related to international differences in valuation ratios. Even among 25 emerging markets, we find that expected future profitability at the five-year horizon can account for 29% of all cross-country P/B variations. Our results show that international investors are able to identify substantial cross-country differences in future earnings prospects and incorporate them into stock market valuations.
Keywords: International valuation ratios; Cross-sectional variance decomposition; Price-to-book ratio; Price-to-dividend ratio
JEL Classification: M41, G15
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