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This is becoming an almost regular discussion in the Barua residence – are Chinese valuations at bubble levels? Finally, instead of quoting from various newspaper articles and gut feel, I decided to actually take the time out and do a very basic valuation.

This article is slightly divergent from the regular trend of my articles but the impact of China - positive or negative – is felt and will continue to be felt by any and every industry – tech included.

I picked up on the Shanghai Composite for a first look rather than the Hang Seng as being more broadly representative of the Chinese market.

The first thing to look at is the market valuation, the P/E multiple and then, what is the growth that this multiple implies. The Shanghai Composite 52 week range has been 2,274.9 to 3,478.01. The current index value of 3074.576 is at 88% of these highs. However it is at 50% of the market high of 6124 on October 16^th, 2007. To put that in context, the S&P 500 is currently trading at 1165.8 which is at 76% of its highs of 1530.2 from May 31^st 2007.

Now to traditional valuation.

Step 1: The P/E multiple

Quoting data from the Bespoke Investment Group, the trailing P/E multiple for China is 12x. This in comparison to India at 9x trailing earnings, Brazil 9-10x trailing and Russia at 2.5x.

Step 2: The cost of capital for Chinese equity

Risk free rate: The risk free rate that I’m using is the 10 year US government bond yield plus the difference in inflation between the two countries. The 10 year bond is at 3.663%.  US inflation according to the Feb BLS numbers is at 2.1% while Chinese inflation hit its highest level in Feb at 2.7% (Note: this is a significant growth considering that inflation from the IMF October 2009 world economic outlook for China was 1.9%). So now we have our R_f at 3.663% + 0.6% which is 4.263%

Beta: I am taking a bit of a short-cut for beta. The beta of the iShares FTSE/Xinhua China 25 Index Fund vs the S&P 500 is at 1.3. For want of a better data supply for the moment, I am rounding off to a beta of 1.5.

Market risk premium: The industry standard for a long term market risk premium is between 4.5-5.5%. Let’s stay mid-way – 5%. 

And that brings us to a cost of capital(r) of 4.263+1.5*(5) which is 11.763%. Putting that in our standard valuation formula of P/E = 1/(r-g), we have an implied growth of 3.4%. To include a range, I’d also like to consider the P/E multiple of the iShares FTSE/Xinhua China 25 Index Fund which is 22x leading to an implied growth of 7.2%.

And so, we come to the final step - comparing the calculated growth with the projected GDP. Last week, the World Bank revised their growth projections for China from 9% to 9.5% (the official growth target is 8%). This revision is in spite of the fact that we will see some Chinese monetary contraction due to the high inflation and the aberration that, temporarily, short term interest rates (one year deposit rate of 2.25%) are currently lower than inflation.

Summarizing, we now have actual growth expectations for the Chinese economy at 9% when the market is valued for a far lower growth ranging from 3.4% - 7.2%.

So then, where’s the over-valuation and the bubble?

And finally some basic technical analysis courtesy Bespoke Investment Group

I appreciate this is a very simplistic look at a very complicated issue - comments will be most welcome.