Business Quality: Calculating the Value Drivers of the business

To get back to the other main question, can companies with lower ROIC not create better Value. Yes they can, if we go back to the Economic Profit definition

Economic Profit = Invested Capital x (ROIC - WACC)

If returns on capital are too low, high Invested Capital (high growth)could destroy value. Conversely, earning a high ROIC on a low capital base may mean missed opportunities.

This clearly shows us that size of** Invested Capital also matters.Consider two companies starting at the same time with identical expected return on capital over their cost of capital. However one company plans/can invest twice as much as the other. As a result, the company withhigher investment**(and thereforefaster growth)should have ahigher value, despite identical returns on capital. It becomes clear that both_growthandreturn on invested capital_drive “Value”.

So a better perspective to look at asset-heavy companies like Astral or BKT (creating value over medium to long term) would be look at the Economic Profit generated by them, which takes into consideration the size of Invested Capital that makes for higher growth too.

The difficulty I run into there is that EP is not a ratio. So the current scale of one business versus another ends up confusing me.

Any ideas on how to use the Economic Profit measure across companies??

-Donald

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Attached

Mayur_Economic_Characteristics.xls (11 KB)

Donald,

The size of the IC also matters but too much is not necessarily good. By the law of diminishing returns, it is more difficult to grow fast on a larger base. Reliance grew much faster in the 70s and 80s than it can possibly grow now. Paradoxically, they have been a victim of their success, as being a larger company the opportunities you can consider are also diminished. In simple words, its easier to double 10 crores than 100,000 crores.

I guess the best level of IC is somewhere between too small and large.

Thanks Dhwanil & Donald,

For bringing out the key differentiators.

below is EP growth for all

'12 '11 '10 '09

Mayur 35.9 50.5 346.2 22.6

Astral 44.48 17.54 -414.14(Consider This +ve as it is growth) -159.96

BKT 31.9 -27.4 293.0 -46.2

Kaveri 184.9 198.7 -45.9 4.2

What I can make out this pattern is if there is a sudden growth in the EP( Increased Capital employed and high RoCE),

the company is a candidate for good capital allocation. This helps in timing of that allocation as well.

So if I would go with this

mayur should have been loaded in 2010

Astral in 2010

BKT in 2010

Kaveri in 2011

But when to exit, still need to be figured out.

And as Dhwanil pointed out earlier, this is not the only thing to look for, there are other factors as well.

Seniors, Please share your views on this…

To put in simpler words, when a company with high RoCE puts in capital in the business, sooner or later it should reflect in the stock price.

Super discussion everyone and so much to learn. A big thanks you to all. Can someone help me with a basic question please. In the asset turnover ratio calculation which asset to do take in thedenominator?

like say from this sheet for amara raja which will be the correct figure http://www.amararaja.co.in/annual_reports.asp

Thanks everyone, i think i was confusing between “Fixed Asset Turnover” and “Asset turnover”.

For the dupont analysis, Asset Turnover

can be taken as “Assets = Liability + Equity” - (Cap 5 , Pat Dorsey’s book)

theclarityin ROEbecauseit

Hi donald,

I concur with the view that in terms of identifying a better quality business, ROIC scores slightly higher than ROE. In my opinion, ROIC is free from independent of financial structure of the business and hence can be more useful in understanding attractiveness of the business. Having said that, I would like to point out here that typically for asset light businesses, ROIC and ROE tend to converge and do not vary widely as depreciation and interest are relatively smaller and only big differentiator is tax . If I come across a company where ROIC and ROE sharply differ, it unsettles me as most of the times it is due to leverage.

In my opinion, the best business is one which has both high margin (sustainable for >=15%) and is asset light. Case in point Triveni Turbine, Bajaj Auto. Thereafter comes business that has decent margins(around 10%) and are asset light( mayur, atul auto).

As charlie munger always recommends, elementary mental models are immensely useful tool in sharpening our analysis. I feel base effect is one such mental model that is very relevant for investment analysis. We all know that it is much easier to grow at higher rate from a smaller base than a larger base. This surely is the case for the companies. So it is much easier for Atul Auto to continue to grow at 20% rate from revenue of 300 crores and 5% market share than Bajaj Auto to grow at the same rate. Hence in terms of probabilistic thinking, I would assign higher probability for Atul auto growing at 20% for 5 years than probability of same growth achieved by Bajaj Auto. Thus companies which have large opportunity size and smaller base (compared to opportunity size) shall get preference over companies that have already garnered sizable share of opportunity size. In Mayur’s concall, Mr.Poddar hinted at the same effect while talking about why he thought economic slowdown has negligible impact on growth in US OEM market because they are too small a player and their base is too small to be affected by slowdown in economy. Thus smaller base may mean higher probability of higher/sustainable growth.

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Donald,

I have been thinking about this question yesterday and I feel that economic Profit could be best used to compare between different companies and also for the same company over time by taking a ratio of Economic Profit to Market Cap of the company.

This is similar to earnings yield. The profit in the numerator and what we pay to achieve the profit in the denominator.

While some companies have a higher capability to generate higher Economic profit as they are well placed to make the capital investment, what does it really cost us as investors to participate in the investment? If we were to invest, we invest at current market cap.

Also while we can see that one company is generating good economic profit like Mayur, it is becoming less attractive as its market cap is increasing. The concept of Market value gap is covered here.

I feel this would be a good ratio to look at and it would be one single number which would be incorporating the available opportunity, capability to tab the opportunity and also if it is inexpensive to the investor.

I will work on the numbers later when I have time… for now I just thought of putting down the thought.

Best regards,

Akbar

** Economic WACC) **

growth)could ofInvested Capital also matters.Consider withhigher investment(and thereforefaster growth)should have ahigher value, both_growthandreturn on invested capital_drive

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EP should be divided by EV and not mcap. Otherwise, ceteris paribus, a highly leveraged comapny will alwyays look better.

Donald,

I have been thinking about this question yesterday and I feel that economic Profit could be best used to compare between different companies and also for the same company over time by taking a ratio of Economic Profit to Market Cap of the company.

This is similar to earnings yield. The profit in the numerator and what we pay to achieve the profit in the denominator.

While some companies have a higher capability to generate higher Economic profit as they are well placed to make the capital investment, what does it really cost us as investors to participate in the investment? If we were to invest, we invest at current market cap.

Also while we can see that one company is generating good economic profit like Mayur, it is becoming less attractive as its market cap is increasing. The concept of Market value gap is covered here.

I feel this would be a good ratio to look at and it would be one single number which would be incorporating the available opportunity, capability to tab the opportunity and also if it is inexpensive to the investor.

I will work on the numbers later when I have time… for now I just thought of putting down the thought.

Best regards,

Akbar

** Economic WACC) **

growth)could ofInvested Capital also matters.Consider withhigher investment(and thereforefaster growth)should have ahigher value, both_growthandreturn on invested capital_drive “Value”.

-Donald

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Dear Akbar,

Thanks for the pointer on EP/MarketCap.

This certainly holds promise. What you say makes sense to me - similarilty to earnings yield.Also as you said the concept of gap with Market Value may get covered with this.

Let’s work in the numbers for a few companies and see what that throws up!

Thanks again.

Donald

Dear RasKhem,

Can you elaborate? Please explain the linkage marketcap w leverage

Thanks

Donald

Hi Donald,

There seems to be an error in the data of BKT for FY12. The Fixed asset should be 826 Cr.

Hi Ayush,

Re: BKT My sheet used the 1068 Cr Fixed Assets figure from Q2FY12 results. Forgot to update in this sheet after Q4 results. Thanks.

Q4FY12 results have Fixed Assets as 1278 Cr. Similarly Working Capital (excluding extra cash) is also higher at 923 Cr. by 1HFY13 Fixed Assets have climbed to 1750 Cr.

I think you have not taken into consideration the capital work in progress ~450 Cr as mentioned in AR (under the Fixed assets category).

Dear RasKhem,

Can you elaborate? Please explain the linkage marketcap w leverage

Thanks

Donald

donald,

i think it makes sense to consider Enterprise value instead of market cap. I always estimate EV while looking at a company so that i am not fooled by the market cap without considering debt.

Hitesh,

The comment of using EV vs MarketCap is valid in general.

However in this EP calculation, we use RoIC, which is a measure designed to be independent of capital structure, so we can compare RoIC across all companies with or without debt.

EP/EV = Invested Capital (RoIC-WACC)/(MarketCap+Debt-Cash)

So my reasoning is if we are not using Debt in the Numerator, we shouldn’t be using Debt in the Denominator - else the results will be inconsistent across companies with different capital structure.

Invite comments. RasKhem - was your comment essentially the same as Hitesh’s?

Donanld,

Lets take a case of a company with IC 100, ROIC 20%, coc 15%. Here, EP = 5.

Lets assume that the value of this company is 100.

Now assume two different capital structure for this company: 1 no debt 250:50 debt

As Mcap = firm value -debt

Case 1 mcap 100 ; case 2 mcap 50

EP/Mcap in case 1: 5%; in case 2: 10% (case 2 is looking twice as good as case 1 when the underlying business is essentially same. The only difference is financial leverage)

If we use EP/EV, it is 5% in both case. Leverage does not change the matrix here.

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Dear RasKhem,

Can you elaborate? Please explain the linkage marketcap w leverage

Thanks

Donald

While the argument looks logical, its perhaps incorrect.

Market Cap is not derived from EV. It is the other way round.Market Cap is determined by the price investors are willing to pay for a share in the business, which changes dynamically in the market. EV is a derived Value.

My point is for any ratio to be meaningful, the numerator and denominators have to be consistent. You cant ROIC on top (which is debt agnostic) and take EV in the bottom (which uses debt).

This aspect is emphasised in the Copeland Valuation Book, pgs 163-164, when it points out the inconsistencies of using say Return on Total Assets. Have a look.

In any case, we should first see what the data throws out, and no harm in computing both sets of figures for comparisons sake across companies - I guess we will know better.

-Donald

Hi,

Like Donald mentioned in one of the posts above, its important to look at the invested capital too i.e… the size of opportunity. A company may be having good nos and ROE etc, but if they are not growing it may not work out very well. One example we may look at is - comparison of Goodyear vs Balkrishna

http://www.screener.in/company/?q=500168#bs

http://www.screener.in/company/?q=502355#bs

Over last 10 years though the quality of earnings have really improved in Goodyear but their BS size has increased just 2.5 times from 125 Cr to 315 Cr

While in the case of BKT, the BS size has grown 14times from 190 Cr to 2740 Cr

Similarly in the case of Astral, the reason for re-rating has been the opportunity size. The company has been growing at 40%CAGR for last 10 years and has potential to maintain 25-30% CAGR for next few years.

Ayush

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Going by your logic, the company in my example should have same mcap irrespecive of the capital structure. Lets say 100cr mcap. If Invested capital is funded by zero debt in case1 and 50cr in case 2. Then, which case is more attractive? Obviously case1 with no debt. Which matrix captures this difference? EP/EV. EP/mcap does not caputre this difference.

Matching of numerator & denominator happens when you use roic & ev because roic is return on invested capital and invested captial is equity+debt.

In roic/mcap, there is mismatch in numerator and denominator because roic is return on entire capital (equity+debt) while mcap is the price of only equity.

Else, one can use delevered RoE / Mcap. Delevering is explained in copeland where authors talk about delevering of beta.

round.Market