Come September” is a catchy tune but finance executives, especially in the US, are unlikely to think of it fondly. That’s because September 2008 marked the end of Wall Street as we knew it. Some people had hoped that the earlier collapse of Bear Sterns presaged the end of the crisis. As it turned out, Bear was just an early warning. With a series of bankruptcies and bailouts the US financial services landscape has changed irrevocably. The seriousness of the situation has been accentuated by several countries reporting shrinking or recessionary economies. What began as a leverage crisis and credit crunch has turned into a full-blown economic crisis affecting the entire world. But is the worst over?
That’s a difficult question to answer, especially since bad news has moved from the stock market to a different theatre—main street.
India is no exception. It was only in September that the emerging India growth story took a drastic turn for the worse. Until then, experts had said India would not be affected to the extent of a slowdown in the US. Since then, it has become increasingly apparent that the global credit crisis is affecting India much more than expected and in more ways than anticipated.
Big Picture (Graphic)
Comparative View (Graphic)
Pullers & Pushers (Graphic)
Impact assessment has become an ongoing exercise. The global credit boom fuelled India’s exceptional growth rates over the past few years— but what once promised to be a secular, long-term bull run came down with a thud in 2008.
The Indian stock market is down to its 2005 levels: it has lost in a year what it gained in at least three years (see chart on the BSE 500 Index).
So, what happened?
Is it a mere coincidence that the Indian markets began rising in 2003, when the US economy started recovering strongly against the backdrop of aggressive cuts in interest rates? Not likely—on looking back, it seems that US was not just cutting interest rates, it was determining the price of money at a global level. India, given its need for capital and its inherent currency linkages, could ill afford to run an interest rate policy that would be directionally different from that of the US. This essentially meant that money was easily available both domestically and in international markets, and this cheap money fuelled huge expansion plans of Indian companies, pushing our GDP (gross domestic product) growth rates closer towards double digits. Of course, the inherent demographic advantages and the benefits of broader policy changes including globalization have contributed towards the India growth story.
Sign of the times: The BSE building. The market has lost in a year what it gained in at least three years. Ashesh Shah / Mint
However, these seem to make relatively a marginal impact—India’s GDP growth is expected to slow in today’s tighter liquidity environment.
Does this mean that India’s much-touted fundamentals are no longer as sound as they once were?
Or, conversely, is India a better investment haven today than it was in 2005?
We attempt a fact-based response and our verdict is: India is just as good an investment option today. However, the business confidence, performance expectations and the sentiments in general are much lower today than what the country can possibly deliver.
Let us compare India in 2005 with India today (see chart on India’s fundamental performance).
GDP growth then was around 9%, and is now more in the region of 7%.
However, the overall GDP today is around 50% higher at Rs46.49 trillion than it was in 2005. The country’s total foreign exchange reserves are $242 billion—around 85% higher than in 2005. Oil is trading at prices below 2005 levels and this is a huge positive for the economy.
It is interesting to note that while foreign direct investment has increased almost 10 times, possibly a signalling faith in India’s long-term prospects, inflow from foreign institutional investors (FIIs) has decreased, much as expected, corroborating the near-term credit crisis across the globe. And while exports have increased, the country’s trade balance has turned negative, and with the depreciation of the rupee, this is cause for concern.
The so-called broad money (M3) is at 1.7 times more and is around 87.53% of GDP today against 86% during 2005, and the situation seems just as good if not better. The cash reserve ratio (CRR) is higher by 1.5% and provides flexibility to manage the liquidity and inflation trade-off.
Similarly, interest rates at a roughly 3% higher than in 2005 provides an opportunity to fuel growth by paring the rates. The overall deficit in 2009 is 6% of GDP compared with 4.5% in 2005. However, given that this is an election year, can we really expect the policymakers to show the discipline to reform? Quite unlikely, given that we don’t even have a “full-time” finance minister in such testing times to see us through!
Still, in sum, India’s fundamentals in February 2009 are just as good and can be made better than those in 2005.
However, this is not complemented by sentiments and performance expectations (Exhibit C: India’s sentiments and expectations).
We analyse, again as in February 2009: market capitalization as a proportion of GDP – which reflects the health of equity markets; the price-earning (P-E) multiple, typically considered as the barometer of valuations; the Business Expectations index—a composite index reflecting views of businesses multiple parameters including overall business and financial situation, order books, capital requirements, human resources and others; and the explicit future growth value as a proportion of total market value—a reflection of expected improvements in the economic profitability of a business.
In February 2009, all these are lower than they were 2005!
The lower future growth expectations could well reflect and explain the lower earning guidance, lower order books, depressed profit margins, etc. However, has the pendulum swung to the other extreme against the backdrop of the global credit crisis?
Are we staring at a fundamentally strong but undervalued India today? And is this the time to invest in India? Let us evaluate the P-E multiple—a lower multiple may well reflect receding expected growth today compared with 2005. However, if we adjust for growth expectations, then we arrive at an interesting conclusion—embedded GDP growth rate in the valuations is about 6.3%. This essentially means that this is the “hurdle rate” for the Indian economy to justify existing valuations. It is interesting to know that government’s own estimate is 7.1% for 2008-09.
Still, even if I were to go back to the old adage of the market knowing best, is 6.3% a difficult target? And what can India do to beat this minimum expectation or hurdle rate?
Value creation is all about performance relative to expectations; should India outperform this expectation, then—let me stick my neck out to suggest—the markets will take cognizance of the fact!
Performance of Indian business
Indian companies account for around 72% of the country’s GDP and will be expected to play a pivotal role if the Indian economy has to beat the 6% GDP growth rate hurdle. However, the dip in the business confidence index reflects a sober, if not sombre, mood and the steep correction in the stock markets will require Indian firms to clearly evaluate performance expectations and craft appropriate strategies to meet, and ideally beat, these expectations.
We take a proxy universe of 500 companies to represent Indian industry and evaluate if Indian industry created wealth between 2005 and 2008 (latest numbers are still not available for all firms, so the study restricts itself to late 2008 numbers). While the answer in general is a “no”, it is heartening to see a few pockets that have created superior wealth. Does the underperformance of most companies come as a surprise —particularly when “managing for value” has become a popular refrain?
Not really, because in the real world the basics of “managing for value” seem to be forgotten with alarming regularity —managing a business for value creation is not just about being the biggest or the most efficient; it requires an appropriate balance between both size and efficiency and fundamentally rests on the principle that companies are supposed to take capital from investors and make it worth more.
However, most lay investors and unfortunately many companies tend to focus far too much on size and earnings-based metrics such as market value, revenues, earnings and earnings per share. Such metrics do not take into account how much additional capital has been poured into the business to generate the additional income and fail to answer the key question that addresses the success of the management: Has the value of the shareowners’ investment increased, and if so, by how much?
While MVA—market value added or management value added—provides the “goal”, it is EVA—economic value added—that provides the mileage tracker towards the goal.
Interestingly, MVA is mathematically exactly equal to the NPV, or net present value, of the business, and EVA is effectively the NPV per year and is used to track business performance.
Indian companies have focused on size, not value creation
While about 480 companies have increased in size, only 128 companies have actually grown their MVA (see chart on fundamental performance and market response). Interestingly, MVA per unit of capital has increased for only 73 companies—which essentially means that only about 15% companies have made contributions to increase the value of the capital over the three-year period. In a similar vein, around 305 companies have improved operating margins as well. Similarly, the aggregate operating margins of Indian companies have increased. However, this has been at the expense of poor capital turnover and resulted in a minuscule rise of just above 3% (or 1.1% in terms of compounded average growth rate) over the past three years.
Companies have focused on profit and loss, but there is scope to better manage the balance sheet
Operating margins suggest the amount of profit generated through one unit of revenue and reflect how effectively the P&L (profit and loss account) is managed, while capital turns denote the amount of capital required to generate one unit of revenue and reflect how well the balance sheet is managed.
It is interesting to see that over 2006-07, both the capital turns and operating margins have improved, leading to an increase in MVA of about Rs14.5 trillion (see chart on movement in net operating profit after tax or Nopat margin and capital turnover). But managing for value is not simply growing both capital turns and operating margins; it is about managing appropriate trade-offs between P&L account and balance sheet; between growth and efficiency; and between near-term and long-term performance. It is such decisions that separate winners—the positive MVA companies—from the rest. A combination of operating margins and capital turnover is reflected by the return on capital employed and adjusting this return to the risks of investing capital will indicate the EVA spread and provide a tool to make appropriate trade-offs. For example, while both winners and the rest have similar revenue growth and differentiate little on the profitability —the P&L items—it is truly the better balance sheet focus that separates winners from the rest (see chart on performance of positive MVA firms compared with negative MVA companies).
Winners have fine-tuned the art of making short-term and long-term trade-offs better than the rest
In a bullish business environment driven by strong liquidity, it is relatively easy to deliver growth or increase size—however, what really counts is the “value growth” which requires much more discipline and sobriety to not get carried away. It is only when the tide turns that one knows who is swimming naked. We have observed time and again that the winners simply tend to follow a basic discipline: setting right goals, incorporating distinctive strategies, allocating resources, tracking right performance and enabling superior execution. The chart on winners corroborates the view—while the winners have grown the top line just as well as others, they have shown better EVA growth and have created wealth. The rest, in contrast, have grown revenues, but have actually reduced EVA—and the markets have taken cognizance of this because they look for an improvement in EVA.
A very common but very unfortunate misconception among many companies that have only a basic familiarity with value-based management concepts is to focus excessively on whether the absolute value of their business’ EVAs are positive or negative. In our experience, there have been many negative EVA companies that have consistently improved EVA and have created wealth for their shareowners, while quite a few positive EVA companies have failed to sufficiently improve EVA and thus have not adequately compensated their shareowners. Absolute EVA—positive or negative —does not matter. What matters is EVA improvement; in fact, markets evaluate EVA improvement relative to expectations. The focus in value creation is on sustained EVA improvement—specifically on understanding how much EVA improvement is good enough.
Our survey suggests that while about 265 companies have improved EVA, all of them have not delivered wealth to shareholders—however, all the companies that have created wealth for shareholders have improved EVA!
The catch here is in terms of understanding how much EVA improvement is good enough, and then going out and beating this hurdle on a sustainable basis.
Managing for value is all about improving performance relative to expectations!
Value is forward-looking—companies need to estimate the embedded forward- looking performance expectations and ensure that the strategic choices they make meet, ideally beat, these expectations.
We used our proprietary frameworks to disaggregate value.
We began by asking what would be the value if a company continues to generate the current level of operating economic profits (EVA) forever; this steady stream of future EVAs was discounted back to today’s terms at the company’s cost of the blended cost for both debt and equity. To this we added the total economic capital employed in the business. This reflects the company’s value if it were to maintain its current level of profitability forever—its current operations value (COV).
However, the enterprise value is different from the COV and this difference is a reflection of growth (or degrowth) expected in the business. This is future growth value (FGV).
We used FGV to compute the performance expectations measured by EVA improvements over the period 2005 to 2008. Companies that have delivered performance above these expectations tend to create shareowners’ wealth.
Indian companies on average have failed to deliver the expected performance over 2005 to 2008—and as a consequence have not created shareowners’ wealth. However, if we dive deeper, there exist the valuable pearls—companies that have created superior wealth, across sectors that beat the rest by a distance (see chart on distribution of MVA and Delta MVA for 500 companies).
Around 80% of MVA in India can be attributed to 10% of the companies. More interesting is the fact that around nine times MVA improvement can be attributed to only 10% companies, while the rest have eroded MVA over the period.
Hindustan Unilever Ltd (HUL) has outperformed expectations to create wealth
The revenue growth of HUL is just as good as, in fact a shade lower than, its peers. However, it has made impressive trade-offs between growth and efficiency, P&L and balance sheet to improve EVA (see chart on snapshot of HUL’s fundamental performance).
HUL has shown substantial improvement in capital turns to deliver EVA improvement by about Rs724 crore in the period 2004-05 to 2007-08. However, there is more to this.
Our analysis went back to 2001 to evaluate the expectations of performance embedded in HUL valuations and looked at expected EVA improvements over a period of three years.
In the period 2001-04, HUL underperformed these expectations (see chart on EVA performance gap) and, not surprisingly, the markets took cognizance of this.
However, in a similar exercise done in 2004 to set expectations and evaluate performance, HUL comes as a winner. In fact, HUL has continued to improve EVA relative to expectations and has emerged one of the few companies that have delivered superior wealth for shareholders even when the rest of the markets have delivered poor returns.
Lupin and Cadila—a study of similarities and contrasts
More interesting is the comparison between Lupin Ltd and Cadila Healthcare Ltd —key players in the Indian pharmaceutical sector. In 2005, Lupin and Cadila were relatively similar on key parameters (see chart on fundamental performance of Lupin and Cadila in 2005).
However, while Cadila was EVA positive, Lupin was EVA negative in 2005. We evaluated the performance expectations for both by using our FGV framework.
The proportion of FGV in the enterprise value for Cadila is 30% and for Lupin is 40%— which essentially means that all else being equal, Lupin has to deliver more EVA improvements than Cadila.
In reality, over the period 2005 to 2008, Lupin has outperformed its expectations, while Cadila hasn’t—although both have delivered positive EVA and EVA improvements (see chart on EVA improvement relative to expectation).
Lupin emerges as a winner and needless to say this is reflected in the share price as well.
The moral of the story: Absolute EVA does not matter, what matters is long-term improvement in EVA relative to expectations. Therefore, companies need to understand how much EVA improvement is good enough to set value based strategic goals for their firm (i.e., linked to growth in MVA/EVA) as not all improvements necessarily lead to shareholder wealth creation: conventional goals (growth in market share, sales, profit after tax, return on equity, even market capitalization) can often end up not creating as much shareowner wealth as they originally intended. This will set the tone to craft appropriate strategies and allocate resources to meet and ideally beat these expectations.
Thereafter, companies should incorporate value-based management principles, align the firm’s performance scorecards, systematically identify, prioritize and routinely monitor the drivers for both short- and long-term value creation…and create performance management and reward systems to energize the organization to consistently outperform share owners’ long-term expectations.
Future growth value, or FGV, is computed by deducting the value of the perpetual stream of current profits from the total market value.
EVA, or economic value added, is the economic profit after deducting the cost of all the capital employed (both debt and equity capital) in the business to generate the operating profit—in essence it marries the P&L and the balance sheet to provide an economic perspective.
Sanjay Kulkarni is the head of management consultant Stern Stewart’s Indian operations.
Write to us at firstname.lastname@example.org
Graphics by Ahmed Raza Khan