Indian firms have always had high returns on equity (RoE) and this fact has often been used to justify the premium the Indian market enjoys to its peers. Will this advantage continue? Why do Indian firms have high RoEs?
These are the questions analysed by a recent strategy report from Kotak Institutional Equities. It analyses the factors behind higher RoE and cash return on cash invested (Croci) earned by firms, and concludes that these factors may not sustain in the next few years.
RoE represents what shareholders earn on their capital. Croci represents the return generated by the company on the total capital invested. It is made more rigorous by excluding non-cash items such as depreciation, goodwill and the effect of non-recurring items such as revaluation of assets or foreign currency liabilities.
Kotak’s analysis shows that RoE of the firms which make up the Sensex has declined in fiscal 2009 and will go down further. Historical figures have been affected by higher competition in sectors such as auto, telecom and cement, weak commodity prices, expensive overseas buys and maturing of businesses such as information technology.
Graphic: Naveen Kumar Saini/Mint
Sectors such as cement, auto and telecom will continue to pull down RoE, though higher commodity prices could result in better RoE for cyclicals. Consumer, industrials and software sectors are expected to be stable.
That’s not all. The report says the decline in RoE can be swift and unexpected, as in the telecom sector: “We note that almost all sectors face the threat of deterioration in returns given their high profitability and excess returns compared with the cost of capital. We highlight the example of the Indian telecom sector that enjoyed fantastic profitability and returns until the entry of new players resulted in enhanced competition and slashed returns quickly.”
Croci for the Sensex firms declined in fiscals 2008 and 2009. It is projected to recover only in 2011, though it will still not reach the high of 2007. It will converge with the cost of capital over a period of time, and a wide variance is seldom sustainable.
The report cites how growing competition is going to lead to lower Croci for sectors such as cars, two-wheelers, cement, telecom and some consumer segments. The removal of fiscal incentives such as backward area benefits may erode the long-term profitability of firms in sectors such as automobiles.
In the energy sector, stricter implementation of regulations could lead to lower returns for gas transportation companies. In metals, returns could collapse if fundamentals become relevant over a period of time, compared with the present situation where financial speculation in commodities is driving performance. It also expects Croci of technology firms to fall, driven by commoditization of the business, need for higher investments, increasing costs and tax rates.
So, is it all doom and gloom? One must not underestimate the ability of Indian firms to come up with innovative ideas to tackle adverse situations. That and rapidly changing consumer trends could lead to hitherto unknown growth areas too. A common goods and services tax and the new direct tax code could make a significant difference—good or bad—to firms.
But these are known unknowns. Kotak’s report attempts to make investors use RoE and Croci to stress-test its valuation matrix. If history is any indicator, however, its voice of reason is unlikely to be heard over the din of hype.
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