In the financial world, ratios are the most important parameter to analyse the companies. Ratios make a similar conversation when we compare different companies in any parameter like different industries, different segment, ratios make the story smooth and easy to compare. There is ample of ratios in the financial world where the big bull talks. Some renowned ratios are P/E, P/B, ROE ( Return on Equity), ROCE( Return on Capital Employed), ROIC( Return on Invested Capital), ROIC( Return on incremental Invested Capital), D/E( Debt to Equity), EV/EBITDA ( Enterprise Value to Earnings before Interest, Tax, Depreciation and Amortization). Gradually we will cover up all the ratios and try to explain in a smooth manner. On this part, we are just focusing on ROCE as it will help you to Understand the Below scenarios.
ROCE is Return on Capital Employed. This term sounds better but what does it means and how we can calculate this?
ROCE is a measure of company earnings on the total capital Employed ( Equity+ debt)
What is EBIT?. EBIT is Earnings Before Interest and Tax. we deduct tax part from the EBIT as it is mandatory to pay corporate tax, now the earnings which left by the company is just for Debtholders( Banks, Bondholders, Debentureholders etc) and Equity holders ( Preference shareholders, Equityholders Etc). EBIT after tax is divided by total capital employed (Debtholders + Equity holders) to get a certain remark that how much company has earned on the total capital employed. ROCE is one of the most important ratios to analyze the company.
There is a research report written by Michael Mauboussin in which he explains the concept of economic profit and evaluates 68 industries and made certain conclusions which I want to evaluate for the Indian Industries. Michael Mauboussin has evaluated Economic profit by ROIC-COC ( Return On Invested Capital- Cost of Capital). we evaluated industries with ROCE-COC which makes Simpler for the time being.
What is Economic Profit?
Economic profit is the profit which is earned above the Cost of capital. So now you will be in dilemma what is Cost of capital. Cost of capital is nothing but the opportunity cost of the business. If you have a business insight, you always compare the return of your business with another opportunity if not invested in the business right, so if you want to set up a business and have some capital to invest in, you will expect minimum earnings from the business so that you don’t lose out the opportunity cost and earn more than that. So what is our Opportunity Cost? In general, many business creators compare their return with the FD rates, G-Sec Bonds etc but don’t you think this rate is not justifiable as these are somehow risk-free or low-risk rates while business is a very risky investment. So we thought to compare the business returns with the 10 year Nifty 50 Rolling returns which are 13.62%. So now nifty 50 returns are our cost of capital. We will understand and evaluate how many companies in the listed segment is earning more than the cost of capital and which can’t.
I have taken sample industries from overall listed segment to compare and analyse which industry is good to bet for the long term and which is not. To evaluate the data, we crunched 10 year Average Economic Profit (2010-2019) and 10-year CAGR stock price (2010-2019), In the Annex-1 we can see that major of the companies have beat the cost of capital while similarly many stocks in the cement sector have delivered a return from -7% to 38% CAGR, you can also analyse in the annexe-1A that majority of the cement stocks has delivered a positive return. Economic profit justifies that industry has delivered a good return compared to nifty 50 rolling Return.
( Disclaimer- Calculation of economic profit and stock returns depend on the listing of the stocks, we have made calculation accordingly to compare on a similar line basis)
Similar analysis made on sample industries which are as follows
Heavy Electrical Equipments
Oil Marketing & Distribution
Personal Care Products
Roads and Highways
Tea & Coffee
Exploration & Production
You have noticed in the above charts that there is an almost positive correlation between economic profit and Stock return but in some industry like hotels have a negative correlation between the stock price and the economic profit. we can make many conclusions like, sector cyclicality, assuming that hotel industry will start earning above cost of capital, sotheir can be some outliers for the industry analysis, while if you obverse majority of the industry has delivered the positive economic profit which has been reflected in the stock prices. So whenever you want to invest in the industry just analyze did these industry has performed well in the past, did industry can earn economic profit for the years, can you forecast a good demand and growth of the industry, if you can get all positive, bingo!!! you hit the right industry.
That’s all for today.
Thanks for reading,
Credits & Sources- Screener, BSE India.