Record inflows from foreign investors helped Asia's stock markets record hefty gains in 2005. But despite the region's attractions, Asian companies still tend to trade at a discount to Western ones. At the end of 2004, for instance, the median P/E ratio for companies in the S&P 500 was 19.9, compared with 11.8 for big listed companies in Hong Kong and 6.8 for those in South Korea. In other words, even if a Western company and an Asian one have the same earnings in any one year, investors tend to be willing to pay more for the shares of the former, believing it will create more shareholder value.

Higher risk factors, such as corruption and uncertain regulatory regimes, are often cited as the explanation—and in some cases they play a part. But an important and sometimes overlooked reason why many large Asian companies are valued lower than their Western peers is because of their historical focus on growth rather than on returns on invested capital (ROIC). Asian companies seeking to improve their valuations need to rethink their strategies, and consider carefully not only how best to create sustained shareholder value but also how to communicate progress on this front to investors.

Companies create value when their ROIC exceeds the cost of capital (which takes into account, by itself, any perceived risk). Growth, while an important component, doesn't create value automatically. The cost of growth—the goodwill added on to the price of an acquisition, for example—needs to be calculated as well. Growth only creates value if it also delivers a decent return on capital.

Although these principles sound simple, they are not always well understood by corporate managers. They are, however, understood by many investors and reflected in stock market valuations. It is not uncommon to find two companies in the same industry with similar growth rates but quite different P/E ratios—a measure of investors' expectations of a company's future prosperity—because of different rates of return.

The problem is that many Asian companies have often placed more emphasis on growth rather than on maximizing their ROIC. In the 1980s and much of the 1990s, it wasn't uncommon for Asian companies to boast growth rates of 15 to 20 percent a year. Size was often equated with prestige and power, but rapid growth didn't necessarily mean better performance. Today the ROIC of many Asian corporations remains relatively low—about 9 percent, on average, for large Asian companies, compared with 13 percent for their US counterparts, according to McKinsey analysis.

Asian companies seeking to create more shareholder value need to ensure that their corporate strategies strike the right balance between growth and ROIC. It also means balancing solid short-term financial results and longer-term performance.¹

As many Western companies have discovered, there is a noisy section of the investor community that is fixated on short-term financial results. Consequently, executives find themselves tempted to manage their businesses to meet quarterly earnings expectations by, for example, delaying new investments-even if those projects offer good returns over the longer term. Such actions undermine a company's ability to deliver sustained shareholder value.

The goal of the corporate manager should be to deliver solid short-term results while also tending to the longer-term health of the business; that is, making the kinds of decisions that will ensure that the company performs well year after year. That's what sophisticated investors expect. Hence, in almost all industry sectors in the United States and other developed markets, 70 to 90 percent of stock market value can be explained only by the cash flows predicted beyond three years. Short-term results have far less impact than many executives might imagine.

Finally, senior executives need to explain to investors just where value lies in the business and how they expect to create more—even if their plans entail sacrificing some short-term profits. The purpose of investor communications is not to simply talk up the share price: overly high aspirations will only tempt executives to make short-term decisions that prop up the company's stock but damage future prospects. Rather, the objective is to align the share price with the company's intrinsic value.

Differentiating between various types of investors is also important. A company could, for example, craft a long-term strategic message directed at those investors who are highly focused on corporate fundamentals over a five-year period and another message for others whose interests center on how strategic decisions or news events will affect the company's short-run value.

Given the flow of funds into the region, Asian companies will increasingly come under the scrutiny of institutional investors looking for the best opportunities. By striking the right balance between growth and ROIC, by caring for the long-term health of the company, and by sharing strategies for value creation with key investors, Asian companies should stand up well to such scrutiny.