European stocks are currently experiencing significant valuation discounts, trading at a P/E ratio of 13.2 compared to the U.S. market’s 21.6. This situation may attract private equity investment, but it also leads to a decline in market quality and deters new public listings. Structural issues, such as low growth and political fragmentation, contribute to this discount. Efforts to unify European capital markets face challenges, as illustrated by failed consolidation attempts in the banking sector.
The Significant Discount on European Stocks
The phrase “the discount on European stocks has never been so significant” has become a common refrain among market observers. This highlights the reality that what appears to be inexpensive can remain so for an extended period—a situation often referred to as a “value trap.” This issue goes beyond mere stock market comparisons.
Currently, European stocks are trading at a price-to-earnings ratio (P/E) of 13.2 for the upcoming year, aligning with their long-term average. In contrast, American stocks boast a forward P/E of 21.6, significantly higher than their 10-year average of 18.2. Over the past decade, this disparity has only grown larger. Fueled by a handful of mega-cap companies with extraordinary profitability, the U.S. market is pulling ahead, now representing 74% of the MSCI World index while accounting for only 25% of global GDP.
The Vicious Cycle of Valuation Discounts
At first glance, the valuation discount in Europe might not seem alarming. While the high valuations in the U.S. may cause concern, having a more affordable European market could lure international investors and bolster market activity. Europe is home to numerous high-quality companies that could attract attention.
However, the reality is more complex. Instead of long-term investors, it’s private equity that finds European markets appealing, often making acquisitions there due to more favorable valuations than in the public sector. A recent example includes the Canadian fund Brookfield’s acquisition of Neoen. As a result, many valuable companies are being absorbed by private equity funds, ironically, many of which are publicly traded themselves. This trend leads to a gradual decline in quality within the European market, particularly among small and medium-sized enterprises, which further discourages investor interest.
Furthermore, for companies not yet listed, the discount is a significant barrier. Firms may choose to delay going public in Europe, fearing inadequate valuation, leading them to consider listing in the U.S. or remaining in the increasingly structured private sector, which allows for larger capitalizations.
For companies already on the market, the discount poses another challenge. When attempting to grow through acquisitions, particularly of American competitors, the valuation gap means potential transaction prices can be prohibitively high. Often, the market reacts unfavorably to such acquisition rumors, causing stock prices to plummet and derailing these growth initiatives. A case in point is last September, when Sodexo’s interest in acquiring American competitor Aramark was reported, resulting in negative market reactions for both companies involved.
The structural discount on European stocks largely stems from the continent’s political and economic conditions. Europe is grappling with an aging population and low potential growth, characterized by incomplete economic and financial integration and political fragmentation, with key leaders facing challenges.
This situation is reflected in the numbers: since 2019, European nominal GDP growth has only reached 40% of that of the U.S. Moreover, the expected earnings per share growth for European companies in 2025 is projected to be approximately half that of their American counterparts, with growth rates of +8% versus +15%, despite decent international exposure.
According to the Draghi report, Europe appears stagnant, exemplified by the fact that the three European companies filing the most patents have remained unchanged since the early 2000s, all three being automotive manufacturers. This trend indicates a focus on incremental rather than disruptive innovation, which is vital for creating value. Consequently, discussions primarily revolve around regulating the innovations of others.
In light of these observations, the recurring topic of unifying capital markets in Europe arises. However, this noble idea often clashes with reality. In September, Unicredit expressed its intention to consolidate the European banking sector, targeting the German bank Commerzbank. Yet, the German political landscape and unions united in opposition, fearing that a German flagship would fall under Italian control, despite the official narrative emphasizing job security. Recent reports have suggested that Commerzbank is contemplating job cuts to enhance its appeal to investors and avoid a takeover by Unicredit.