An Evaluation of Chinese Firms’ Profitability: 2005-2013

Abstract

We empirically examine the profitability of leading Chinese firms, benchmarked against comparable US firms, for the period 2005-13. Return on invested capital (ROIC), which excludes leverage effects on performance, provides the primary metric. Averaged over firms and years, the two sets of firms have similar profitability, about 11% annually. Decomposing ROIC into free cash flow yield and invested capital growth, we show that the same ROIC has very different compositions: while the Chinese firms had high growth and negative free cash flows, the US firms had low growth and positive free cash flows. Due to balance sheet conservatism, we infer that Chinese (US) firms’ free cash flow yields and the resulting ROICs have been biased downwards (upwards). After correcting for the bias, we show that Chinese firms have much higher profitability than their US counterparts: 15.1% versus 8.1%. This result is driven by the abundance of growth opportunities in China in our sample period. When we control for the growth rates, we find US firms have been more “efficient” in generating more free cash flows than Chinese firms.

Keywords: profitability, conservatism, free cash flow, invested capital