Risks of ignoring returns

The market rewards firms that compound the capital by valuing them at a higher premium.

Many companies and investors think that growth is the be-all and end-all of value, at the risk of ignoring profitability. Time and again capital markets have proven that over the long term, profitability is critical and growth for growth’s sake can destroy value.


A study of listed companies that constitute the BSE 100 Index indicates that, on an average, companies that deliver better Return on Capital Employed (ROCE) — a comprehensive profitability metric — experience higher valuation, measured in terms of price/book (P/B) multiple at which their shares trade.

In fact, the analysis reveals that firms arranged in ascending order of ROCE, exhibit progressively increasing P/B multiple mean (average). Firms in the lowest ROCE bucket have a mean P/B multiple of 2.27 and median P/B multiple of 1.96, while those that belong to the highest ROCE bucket have a mean P/B multiple of 11.81 and median P/B multiple of 8.34. These findings indicate that ROCE has an important influence on the valuation multiple that a firm enjoys. A firm that can expand its ROCE, can expand its valuation multiple. CEOs who can move the needle can become stars and investors who can spot the inflexion point can find themselves in the land of multi-baggers.

What does this mean?

In simple terms, what this means is: The market rewards firms that can compound the capital they employ in their business at high rates of return, by valuing them at a higher premium compared to peers that compound capital employed in their business at low rates of return. The implication of this is also less dilution in equity for future fund raising initiatives for those firms that are superior managers of capital.

The corollary: While the market expects firms to grow, growth for growth’s sake without a handle on ROCE may in fact be value eroding in terms of market multiple commanded by the firm.

Example of ROCE-linked difference in valuation multiples can be found both within and across industries — textiles vs FMCG; IT services vs manufacturing; HDFC Bank vs ICICI Bank (more on these in subsequent articles). The takeaway is that ROCE consists of both industry-specific and firm-specific components.

Even Warren Buffett has gone on record that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact. In fact, he has admitted that his original acquisition of Berkshire Hathaway, which was into textiles then, was probably his biggest mistake!

Certain industries such as airlines and textiles are by nature poor compounders of capital over the long term due to certain intrinsic characteristics such as capital intensive nature, wafer-thin margins, inability to pass on cost increases to customers etc. However, few companies in these sectors such as Southwest Airlines and Indigo are able to keep their heads above water due to their astute strategies.

But taking a look at the IT services or FMCG sector, one can see that even the smaller and less efficient firms can hope to record 20 per cent + ROCE comfortably.

As a result, it is common to see companies operating in low ROCE industries using leverage to boost ROE (return on equity), while companies operating in high ROCE industries find no incentive to lever up and rightly so. This behaviour is best explained by borrowing from Rakesh Jhunjhunwala’s philosophy — “Why risk going to the hotel, when home food is so good?”

Linkage to strategy

A keen eye on ROCE is a must during the ideation and implementation of strategy — be it for running a business or for investing. Unfortunately, abundant and cheap availability of capital can easily cause firms to lose sight of profitability in the lure of empire building.

Arguments such as owning a small portion of large pie is better than a large portion of a small pie start surfacing without thinking about the quality of the pie in the first place.

Such regimes usually lead to investment in mediocre projects, non-core expansion, over-priced and grandiose M&A, and other decisions which lack fundamental soundness but can be justified in the name of growth and market share. This is exactly what happened in the early part of this millennium — with almost every Indian company/group aspiring to raise capital, diversify, pursue M&A and go global. However, during the past few years, Indian firms have had to fight the pressures of not only increasing cost of capital and operating costs (thanks to inflation and commodity bubbles) but also a slowdown in growth.

Needless to say, many companies have experienced erosion in ROCE and subsequently their valuation. The effect is more pronounced in a few sectors (for example, infrastructure-related) compared to others.

Given how important ROCE is as a shareholder value metric, it is surprising to see that most company annual reports don’t even talk about it, let alone steer the organisation towards maximising its outcome. What I have observed is that organisations that have superior ROCE compared to their industry, have a relentless focus on key value drivers. Such organisations link all their strategic and operational initiatives including performance metrics across functions and levels to the key ROCE value-drivers such as fixed asset productivity, working capital turns and operating margins.

Targets are set against these during the planning and budgeting process, and initiatives are prioritised based on how important they are to preserving or enhancing ROCE. As an investor, the next time you find an organisation discussing about its plans on ROCE in its annual report/AGM/ investor meet — sharpen your eyes and ears. One company with good ROCE discipline is Bajaj Auto, which put the small car project on hold, despite having spent time and money in the effort, because it didn’t meet the ROCE requirements.

(The author is a business consultant. Feedback can be sent to perspective@thehindu.co.in)

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