Economic Profit, this is what matters – 10X10Y

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In my last writing we calculated the cost of equity, which is nothing but the opportunity cost of capital.

Here, is an attempt to go further and calculate Economic Profit.

Profit is the income earned minus the cost incurred but Economic Profit is the income earned minus the opportunity costs of the capital employed by the business. 

 As discussed in my previous article, we are considering the returns of investing in the Nifty ETF to be the next best alternative for any business’s capital, and is hence our opportunity cost. This return calculated here, turned out to be 11.22%, and which we’ve considered to be our opportunity cost, or to be our cost of equity in more technical terms. 

Now, how do we calculate Economic Profit 

Economic Profit is the difference between ROIC and Cost of Equity

ROIC or Return on Invested Capital is a measure of the income earned by the company on the capital (Fixed Capital+Working Capital) invested by the business. It is calculated using the following formula=

Why this metric is highly regarded is because it ignores the effect of capital structure, non-core assets and non-core income and tells us exactly how efficient the business is. This is also the primary reason why ROIC makes it perfectly efficient for us to compare companies of different structure and industries.  

While ROIC is a great metric, I used ROCE which is Return on Capital Employed for our analysis because of the readily available data. They are both similar metrics and would probably be a few basis points shy of each other. But note that, in case of detailed study, ROIC is a much preferred metric.

Further on, I tried to compute Economic Profit of all companies (with Market Cap higher than 100 Crores) in a few industries to understand the profitability of the overall industry as a whole.

Why would I compute the Economic profit of an industry?

It’s because of what one of the world’s greatest financial minds Charlie Munger said.

In the 2017 Berkshire Annual General Meeting, Munger said, “there are two rules of fishing, No. 1 was to “fish where the fish are” and No. 2 was “Don’t forget about rule No. 1. 

By fishes he meant companies and by fishing he meant investing. 

In an overall sense it means that, one should invest in industries where there are a whole lot of great companies. What this would result in is that you increase your probability of getting your returns right. If you fish in a pond full of fishes, then even if you’re a bad fisherman you’ll end up fishing the fishes vs a really good fisherman fishing in a pond with very few fishes. In a similar sense, when you invest in an industry that is full of solid businesses, even if you’re a bad/not that good investor or even if things are not in your favor, you substantially increase your probability of getting your investment right rather than if you had invested in a terrible industry with a handful companies doing a decent job (Airline or Textlile Industry)

Thus, to understand and implement this narrative, I calculated the Economic Profit of a few industries. While it was not possible to calculate Economic Profit all the 120 industries in the country, I took my personal favorite industry – NBFCs (Non-Banking Financial Companies). The BSE website distributed the NBFC Companies into two : Finance (including NBFCs) and Housing Finance industry. But having classified my NBFC company into the generic Finance Industry made things difficult. Because the widely spread Finance industry not only had NBFCs but a lot more companies.

The finance industry list by BSE had multiple segments of companies included in it like NBFCs, Investment Companies, Financial Services, etc. coming to about 133 companies. On the hand, the Housing Finance companies which by itself are NBFCs were not included in Finance Companies and had a separate list. Thus, these lists required a lot of modifications. 

So I decided to organise the Finance companies list by BSE into NBFCs, Financial Services and Investment Companies and decided to add the separate list by BSE of Housing Finance companies to my list of NBFCs. This would give us an exhaustive list of all NBFCs.

Now, there were also a number of investment companies in the initial finance list which we filtered out, which surprisingly were not part of the separate industry classified by BSE as Investment Companies. Thus, I also took up the Investment Companies industry by BSE and added my previously segregated investment companies from the Finance industry to compute another exhaustive list of all Investment Companies. Investment companies are very asset-light companies so it would be very interesting to see how the numbers turn up. In addition to this, I also took a service industry segment – Consulting Services and the Integrated Oil and Gas industry, which made RIL the behemoth it is today.

These together were about 200 companies but I ignored companies with a market cap lower than 100 crores. The total number of companies as classified by BSE, amongst all the industries I picked were now about 70 and looked something like this. 

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However, I did the necessary classification discussed earlier by clubbing Housing Finance NBFCs and all other NBFCs into one. I also reclassified the investment companies from BSE’s finance industry list and clubbed it with BSE’s ‘’Investment companies list’’. Here’s what the new classification for our research looked like:

Now, to get to our core task of finding Economic Profitability, the following steps were taken:-

  • First, I calculated the Economic Profit of every company in the industry picked for the last 10 years and took a simple average of the last 10 years to compute the average Economic Profitability of the particular company.
          This was done for all the 70 companies in our study.
  • Now to eventually compute the Industry’s Economic Profitability, I just can’t take the simple average of the Economic Profit of all companies, because a company with just 2000 crores of capital can’t be considered equal to another one with 50,000 crores of capital.
  • Thus, I computed the capital employed (Debt + Equity) of ever company, and added them all together to know the total capital employed of the industry. 
           Using these figures, I calculated the weights of every company’s capital with respect to the industry’s and multiplied it with their average EP of the last 10 years. 
  • Then I finally added these weighted economic profits of every company to get the industry’s economic profits.
           In technical terms, I calculated the weighted average Economic Profit of the industry which made much more sense than calculating the simple average.

Industry 1 – NBFCs 

Starting off with the NBFC industry, which uses Debt as their main source of capital, we’d use Return on Equity (ROE) for a better judgement. ROE is a key profitability ratio that reveals how effectively a company is generating profit from the money that investors have put into the business in form of equity. The higher, the better. 

Finance companies have close to 80-90% of their balance sheet as debt, which would lead to very low ROCE or ROIC and would result in a distorted picture. A better metric for banking and finance companies is ROE (Return on Equity) or ROA (Return on Assets). We would use ROE and WACC (Weighted average cost of capital), the difference of which would be Economic Profit. 

WACC or Weighted Average Cost of Capital (WACC) shows a firm’s blended cost of capital across all sources, including both debt and equity. This is better for us to use rather than the plain Cost of Equity is because of the extensive use of Debt by such companies, which is about 80-85% of the capital employed. Thus, it becomes important for us to account for the such a heavily used source of capital. 

On the other hand, debt computed by us for the calculation is a summation of Debt + Borrowings + Deposits. What primarily finance companies do is borrow money at low interest rates and lend them out at relatively. much higher interest rates. Thus, finance companies have an ability to borrow money at much lower rates than cost of equity, when compared to other companies. This is another reason why using only cost of equity is absolutely wrong. And, also why we’d use WACC. 

The NBFC industry as a whole consisting of 31 companies had a solid Economic Profit of 12.08%. However, the industry had a lot of segments with drastically different businesses, so it wouldn’t make sense computing the Economic Profit of the entire industry as a whole, knowing that the Gold Finance space is rather different than the Micro Finance space. What would make sense is to divide the NBFC industry to even more of such sub-segments and compute their individual Economic Profits. 

With over 13 Lakh crores of capital employed by the NBFC industry, it was worth noting that two segments out of the seven ; Housing Finance and Infrastructure Finance, employed nearly the same amount of capital which was 37% of the industry each. The two industries together employed 75% of the entire NBFC industry. These where the astonishing results and as expected, the segmental EPs were quite different from what we got as the industry average. 

Ignoring the segments and just taking NBFC as a whole, the industry had a 12.08% Economic Profit, which would’ve given us a very confident stance to fish in any part of the pond. While we would’ve still had a good chance of fishing the fee, this additional step done next would’ve shot our chances up even more.

We divided the industry into segements:

Housing Finance Segment

The Housing Finance industry has been posting a solid 15.07%, 3% higher on absolute terms or 25% higher than the NBFC industry average.

Here were some noteworthy observations about the Housing Finance industry: –

  • 3 companies in the Housing Finance Industry employed 89.60% of the entire capital in the segment.
  • Out of the 10 companies that constituted the industry, 8 of them showed average economic profits of 11% to 12.5% which is outstanding. Two of the companies showed extreme results, HUDCO at 4.7% and Indiabulls Housing finance at 24.2%
  • Every company in the industry had their cost of capital under control ranging from 5% to 7% 
  • While HUDCO too had its cost (WACC) under control, the ROE didn’t do a good job when compared to industry standards. HUDCO constantly increased its Net Profit but not in pace with the faster growing Equity. However, we’ve seen gradual better performance in the last 3 years. This means that the industry as a whole could do a better job in the future. 
    The company also had a higher than average tax rate which could have resulted in lower WACC and lower Net Profit.
  • Another company, DHFL which was accused of a 31,000-crore scam is also a part of the housing finance industry. But we shall exclude DHFL from our study as we don’t know the legitimacy of these numbers and will definitely not invest in the company after knowing what we already know. Also, note that this was the only company in the industry to have ever reported a net loss and thus a negative ROE and EP. We also considered HUDCO as an outlier. 
  • HDFC Ltd. had a higher than industry average WACC and thus lower EP,but had one of the highest ROE in the industry of 20% plus. 
  • PNB housing and CanFin Homes had the lowest WACC in the industry, an average of 5.68% and 5.88% respectively, probably because of the strong parentage of PNB and Canara Bank. 
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With a Weighted Average Economic Profit of the Housing Finance Industry at 15.07%, this pond has a set of really good fishes and you probably can’t go wrong fishing in this pond. 

Micro Finance Segment

  • Micro Finance companies had an average Economic Profitability of 0.55% which was much lower than the Industry Weighted Average. It was noted in Micro Finance companies that the company’s performance deteriorated with higher capital employed. 

Diversified Finance Segment

  •  Diversified Finance companies had an average Economic Profitability of 7.96% which was also much lower than the Industry Weighted Average.
  • Diversified Finance companies had 4 companies out of 8 performing extremely well with double digit EP and 2 with close to 10% EP, and the left over 2 not doing all that well, spoiling the industry’s average. We had to exclude the two major outliers Reliance Capital and Spandana Sphoorty, which had -497% and -125% Economic Profit.
  • Cholamandlam on the other has been constantly improving its Roe over the last 10 years, which indicates a high probability of it contributing to higher EP of the industry. 
  • MAS Financials a very well-known small-cap has a solid record of providing 20s% of EP, but the average has fallen to 16.5% due to the last two years of ordinary performance at around 10%. The company also has a much higher WACC than industry average, which in future could improve and contribute towards higher profitability

Gold Finance Segment

  • Gold Finance the Duopoly Industry had an extra-ordinary EP of 16.82%, with Muthoot at 20.17%, the highest average EP in the entire NBFC space of 31 companies. 
  • Manappuram Finance and Muthoot Finance the duopolies of the Gold Finance industry have a reasonably good business profitability. However, Muthoot Finance with more than double the capital, also has more than double the average EP of Manappuram (9.70%) at 20.17%.

Consumer Finance Segment

  • Consumer Finance companies had a solid 14.58% Economic Profit led by the coveted Bajaj Finance
  • In the consumer finance space, Bajaj Finance upon excluding the extremely low one-off 2010 ROE had a 15.03% average economic vs a 13.7% upon including 2010. We are considering 2010 as on outlier and thus considering 15.03%, which is much higher than industry weighted average.
  • Bajaj Finance also had extremely low and constant WACC, at the same time had extremely high and constant ROE, which is the reason for its high EP.

Business Finance Segment

  • Business Finance is the smallest segment in the NBFC space but has been giving an average of 10.38% Economic Profitability.

Infrastructure Finance Segment

  • This segment has given a 11% average Economic Profitability.
  • Just like how 3 companies in the Housing Finance Industry employed 89.60% of the capital, 2 companies in the Infrastructure Finance space employed 82.31% of the capital. They were Power Finance Corporation Ltd and REC Ltd.
  • Power Finance Corporation Ltd, the biggest company in terms of capital, has had a good control over its cost of capital but it’s ROE has been all over the place. The ROE has been high but constantly varies, which is why an average has useful in such a situation. 
  • REC Ltd. has had it’s WACC and ROE but constantly falling. While one is good for the company, the other is not. 

Industry 2 – Investment Companies

For this industry, we used ROE rather than ROCE. It was because of the asset light nature of the industry; thus, it made more sense to subtract COE from ROE to compute EP. To the existing 12 companies from the BSE list, we added 8 other investment companies which were added in the Finance Companies list. Here were the results,

Here were some noteworthy observations: –

  • The industry’s Economic Profit was a -4.91%.
  • Out of the 20 companies that make part of this industry, only 4 showed a decent amount of Economic Profit – Dhunseri Investments Ltd, INDUSTRIAL & PRUDENTIAL INVESTMENTS CO.LTD and MULTI COMMODITY EXCHANGE OF INDIA LTD. and BALMER LAWRIE INVESTMENTS LTD.
  • However, when you come to Dhunseri Investments, which has a EP of -12.64%, the company’s data was available only for the 4 years, in 3 of which they showed a negative Economic Profit and a bump in one year, showing a massive 51.26%, ignoring which will give us the average Economic Profit of the company to be -12.64%. Using this, the industry’s EP would fall even further from -4.91% to -5.37%
  • INDUSTRIAL & PRUDENTIAL INVESTMENTS CO.LTD which also showed a 5.31% EP, has had a constantly falling ROE and thus, EP. One as an investor invests into the future, and would thus likely face a negative EP when looking into the future. 
  • Coming to MULTI COMMODITY EXCHANGE OF INDIA LTD. (MCX) which has had a 6.44%. EP has also had a constant ROE for the last 5 years and has also reported negative EPs vs a point in time when the company used to post Roe in the 30s and EP in the 20s. Figures for the last 5 years have mostly remained rangebound. 
  • Balmer Lawrie Investments is not engaged in any other business activity, except, to hold the Equity Shares of Balmer Lawrie & Co. Ltd. and had the highest EP in the industry of 33.53%.
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Now, when you think about this industry, why are the chances that you would get a good return investing in this industry. It’s better to not fish in this pond. 

Industry 3 – Consulting Services

Now, this industry was peculiar. This industry consisted of only 5 listed players, one of which, Engineers India Ltd held 92% of the industry’s capital. The rest four also had a market capitalization of lower than 100 crores. Thus, based on our research parameters we should consider only Engineers India Limited as part of our study. However, I still did the calculations of every company just to get a better idea. 

Here were some noteworthy observations: –

  • Engineers India Limited Started off as a highly lucrative business with high 30s ROCE but has fallen to mid -teens in the last 5 years. 
  • Thus, EP has also been following the same trend for the last many years but has picked up in the last 2/3 years.

Industry 3 – Integrated Oil & Gas Industry

Coming to the Integrated Oil and Gas industry, which is more or less run by one company alone – Reliance Industries Limited (RIL). 

RIL alone employed 3,85,476 crores, which is 98.36% of the industry’s capital. 

RIL is a humungous company with multiple segments. It’s segments more or less can be classified as followed :-

  • Refining
  • Organized Retail
  • Petrochemicals
  • Digital Services
  • Oil and Gas
  • Financial services
  • Others

However, to compute the Economic Profitability of the Integrated Oil and Gas Industry we took the standalone figures, which included three segments – Refining, Petrochemicals and Oil & Gas. 

Here were the results,

Here were some noteworthy observations: –

  • The first thing I noticed was that RIL’s Integrated Oil and Gas business employed as much as 80% of the entire Housing Finance Industry. 
  • The industry’s Economic Profitability more or less depended on RIL’s performance because of the capital heavy weight that it is. But RIL too had a pretty ordinary EP of 0.85% and the industry of 0.88%
  • However, if we took the weighted average economic profit of the Oil and Gas business, the results were drastically different. 
  • The weighted average economic profit stood at a staggering 10.45% for the Integrated Oil and Gas Business. 
  • Out of the three segments that constituted the Integrated O&G business, only one showed poor performance, without which the EP would’ve been at a 12.9%
  • But looking at the last 1o years data, it was to be noted that all the three segments spoken have been growing their ROCE at an unstoppable pace. On the other hand, their cost of capital/WACC has been at an average of 7.65%, which is extremely low and cost of debt at an average of 2.95% which is unprecedented. 

I also calculated the weighted average economic profit of the company as a whole which didn’t look bad either. 

This was the end of the strenuous but a very important exercise. I hope this little attempt of mine will make you atleast think about looking at the proftibality of the industry as a whole before investing in a certain company. 

This is a summary of the industry’s weighted average economic profitability which we calculated. But I am also attaching another column showing the average Economic Profit which will prove a point stated earlier that, by taking the average of the Economic Profit we will get a much different picture and it makes more sense to calculate the weighted average. 

Thank You. 

Sources – Industry and Company list have been taken from the BSE website. Financial figures have been taken from screener and annual reports.

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Moulik Jain
Moulik is 24, an Entrepreneur, and a successful Angel Investor at Beardo (exited). He is currently one of India's youngest Angel Investors.
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