Sheen is off Indian equities, investors need to get realistic

Stock market investing is very relative. One can say a share price of a company is expensive or cheap only after comparing it to the performance it delivered in the past or that of other companies in the peer group.

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The performance of share prices could be tracked using various methods. One of them and an important one, is the return on equity, or RoE. Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested.

In the boom phase of four years to March 2008, the top Indian companies reported a return on equity of over 20%. In the fiscal to March 2009, this dropped to below 17%. Over the past two years, it struggled to stay around the same range or stayed lower. Indian companies have witnessed strong competitive pressure in sectors like telecom and infrastructure. The input costs have surged across the board and wage inflation has added to the overall pressure on profitability. The Reserve Bank of India (RBI) has hiked interest rates by 2.5% over the past 14 months.

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Hence, an investor in Indian equities needs to get used to a humble return on equity (RoE).

Here are some observations by securities firm IIFL in a note last month on RoE:

1. RoEs of financial services, utilities, FMCG and pharma companies have been reasonably stable through the last eight years;

2. RoEs of autos, after dropping to a third of their FY04-08 average in FY09, have shot past their pre-crisis averages;

3. Current RoEs of the media sector are well above the FY04-08 average;

3. RoEs of technology, oil & gas, and capital goods are down by almost a third to a sixth (4-10 percent) in FY11 relative to the FY04-08 averages; and

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4. RoEs of cement, telecom, construction, real estate and metals have collapsed to about half of their FY04-08 averages.

Here are two main reasons why Indian companies are likely to face pressure on return on equity, going forward.

Cost of equity has gone up

The cost of equity is surging. An analysis by securities firm India Infoline suggests that during the boom phase of five years to March 2008, the difference between return on equity-cost of equity for top 140 companies tracked by the firm was about 8%. By March 2011, this gap has narrowed down to 2.5%. A firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.

The cost of equity is estimated using the risk-free reference rate on the 10-year sovereign gilt yield. This has hovered in the 8-10% region and is expected by analysts to stay higher.

Companies going for large acquisitions

Many companies have made large acquisitions in India or overseas. This has resulted in companies diluting their equity structure. Five years ago, Tata Steel had a return on equity of 36%. For year to March 2011, it has dropped to 20%. Hindalco delivered over 18.7% and now, gives around 14.5%. Bharti Airtel had an RoE of around 25% and now hovers around 12.5%.

The appetite for acquisitions is growing as many companies are choosing to diversify geographic spread of revenue. As companies gain experience in managing large cross-border acquisitions, they will continue to use it to gain market share and leadership positions in their respective sectors. However, profitability is not the same in Europe or the US. Wages are much higher overseas than in India. While some business processes could be moved to India, companies have to ramp up expenditure to maintain revenue growth in developed markets.

Hence, acquisitive companies would see an erosion in the RoE (See table below, figures are in percent).

[caption id=“attachment_47318” align=“alignleft” width=“448” caption=“The table shows returns on equities stack up.”]  [/caption]