Explaining International Valuations

Listing in the US offers a significant valuation premium
 

By: Daniel Rasmussen

Perhaps the single greatest divergence in equity markets has been the continued outperformance of US versus international equities—and thus the widening of the valuation gap between the US and the rest of the world.

Figure 1: Premium of US vs. International Equity Valuations (5-Year Average, P/B)

Source: Capital IQ

The drivers of this valuation gap are hotly contested. Those who argue for US exceptionalism make the case that the US has had significantly higher corporate earnings growth due to the innovations of our large technology companies and that this innovation and growth shows no signs of slowing. Those who argue in favor of international diversification say that the valuation gap has grown too wide to be explained by these fundamentals and that mean reversion is likely.

To test these competing views, we regressed value against the other common risk factors for the top 1,000 stocks globally. We considered major style factors (size, quality, profitability, and investment) and sectors, and then we added a binary variable for whether the company was listed on US markets, with an additional variable measuring the percentage of revenue derived from the US. This regression has a 37% adjusted R-Squared in explaining valuations, which is quite high for explaining variation across individual equities.

This regression can help illustrate how differences in these style factors explain differences in valuations. For instance, we found that companies that were growing faster tended to be more expensive (t-stat of 4.5), and companies that were higher quality tended to be more expensive (t-stat of 9.5).

Below we show how the weighted-average factor exposures impact valuation for US versus international equities. For reference, our global universe has a capitalization-weighted mean of zero for each style factor, so the US market is close to "neutral" at 0.0 on the value factor, since the S&P 500 dominates the market cap-weighting. International stocks are cheaper by 0.6 standard deviations on our value factor measure. In this sense, all other stocks are measured relative to the US market.

Figure 2: Bridge from US to International Valuations

Source: Verdad analysis, Capital IQ

International stocks tend to be smaller with a lower percentage of sales in the US. Other factors like margins, growth, leverage, investment, and sector mix have minimal contribution to the valuation gap between US and international stocks, with each individual contribution rounding to about zero. Differences in weighted-average quality—as measured by gross profit and free cash flow divided by total assets—drive about 1/4 of the valuation difference.

By far the most significant difference, explaining about half the valuation gap, is the domicile of listing. US-listed stocks are substantially more expensive than internationally listed stocks for no reason other than the place of listing.

It’s particularly interesting that the regression shows having a higher percentage of sales in the US results in cheaper valuations. A key driver of this is that several of the US tech giants most responsible for high US equity valuations having a relatively low percentage of sales in the US (Alphabet, Microsoft, and Tesla at around 50%; Apple, Netflix, Meta, and NVIDIA at around 40%). The big question, then, is why half the valuation gap is explained simply by being listed on US exchanges. Even large internationally listed companies with >40% of their revenue coming from the US, like Toyota, Mitsubishi, Roche or Deutsche Telekom (which owns T-Mobile), trade at steep value multiples relative to US peers.

Were a larger percentage of the valuation gap explained by fundamentals, we’d expect such a gap to persist. But given that the valuation gap is primarily explained simply by the location of listing, we think there’s a strong reason to expect a convergence—and therefore to favor international over US-listed stocks, despite their terrible relative performance over the past decade.