Identifying a construction stock: Do's and don'ts - Views on News from Equitymaster

Helping You Build Wealth With Honest Research
Since 1996. Try Now

  • MyStocks


Login Failure
(Please do not use this option on a public machine)
  Sign Up | Forgot Password?  

Identifying a construction stock: Do's and don'ts

Mar 19, 2007

After being in the limelight for the past two years, stocks from the construction sector have witnessed tremendous pressure in the recent market meltdown with the pressure being aggravated by the Finance Minister's clarification that tax benefits under Section 80-IA would not be applicable for entities executing projects through work contracts (i.e. sub-contracting of projects won by the entities).Companies across the construction segments like real estate construction, industrial construction and infrastructure creation have been beneficiaries of the buoyancy in the country's economic performance over the past few years. Especially the sectors of industrial construction and infrastructure are likely to benefit in the future as well, considering that India spends a miniscule percentage of its GDP per annum on such activities, indicating huge potential for growth. While all this may sound like a smooth ride for investors in construction stocks, when it comes to analysing these stocks, the situation becomes a bit tricky, considering the 'not-so-good' disclosure levels. In such a scenario, it becomes imperative for the investors to carefully study any investment proposition from the sector before putting in his/her hard earned money in 'any' construction stock.

In this write-up, we will try to discuss some of the important things that you, as an investor, need to keep in mind before investing in a construction stock.

Construction sector
The construction sector can be broadly classified into three sub-segments:

  • Infrastructure (roads, power, ports and urban infrastructure)
  • Real estate (residential and commercial construction) and
  • Industrial construction (steel plants, textile plants, refineries, pipeline etc.)

Infrastructure: The government spending on infrastructure is the most important demand driver for the construction industry. Since adequate infrastructure is essential for sustained economic growth, infrastructure construction has gained significant importance over the past few years, mainly in the form of development of roads, water supply & sanitation, irrigation and ports projects. In most of the segments of infrastructure construction, the government is focusing on private public partnership (PPP) model to achieve faster execution of projects.

The basic framework for PPP involves constructing projects on BOT (build-operate-transfer) basis, whereby a construction company builds and operates a project for a period of say 20 to 30 years (called concession period) and then transfers the project in a well-maintained condition to the government free of cost. During this concession period, the entire toll revenues collected by the construction company belong to it. Then, there is a second type of BOT contract, called as 'annuity contracts', whereby the toll is collected by the government and is then shared (pre-determined) with the construction company that had constructed the project and is operating the same on behalf of the government.

Real estate: Demand supply-gap for quality residential housing, favourable demographics, rising income levels, availability of financing options as well as fiscal benefits available on availing of home loan are the key drivers supporting the demand for residential construction. In addition to this, demand for office space from IT/BPO segment is expected to continue due to emergence of India as a preferred outsourcing destination. Also, buoyancy in organised retail is expected to result in huge demand for real estate construction.

Industrial: Industrial construction is primarily driven by capacity expansion plans of manufacturing companies, which in turn is dependent upon the aggregate demand in the economy and consequently current capacity utilisation levels. For instance, metal and refinery companies, which have been operating at high utilisations levels, have planned huge capacity expansion going forward, which shall entail large spends on construction activities.

Revenues growth drivers

Balance sheet strength:The Indian construction industry is witnessing market share gains by bigger players. This means that bigger companies are growing bigger and bigger at the expense of smaller players. As per a survey conducted by CMIE, over the past 10 years, the market share of top 30 construction companies has increased from 50% to 90%. This is primarily due to increasing complexity of projects, stricter technical qualifications, and cumbersome process of forming consortiums for smaller players. We believe that this trend will continue going forward and hence investors need to invest in bigger construction companies that are more likely to win orders based on their pre-qualification status (determined by the balance-sheet strength and experience in handling similar projects).

Order book: Order book of a company has a direct bearing on its future revenues. Since the construction business is primarily a tender driven business, strong order book provides revenue visibility to the firm. It should, however, be noted that order book only includes cash contracts and not projects allotted on BOT (build-operate-transfer) basis. In case of BOT, returns are in the form of annuity and toll and are generally spread over a period of 15, 20 or 30 years.

Execution period:For a construction company, revenue is primarily a function of order book size as well as the execution period. The order book tenure (or the execution period) in turn, is dependent upon the order mix of the company. For instance, transportation projects have a lower gestation period as compared to power and tunnel projects. Hence, a company with higher proportion of low gestations projects in its order book is likely to witness higher conversion rate and a faster growth in revenues.

Increased investments in infrastructure and huge capacity addition plans by manufacturing companies have resulted in huge order books for construction companies. We believe that the timely execution of projects in the wake of human resource shortage will be the key challenge for construction companies going forward. Hence, one should be a bit conservative as far as the sales growth is considered.

Margin drivers

Order mix: Depending upon the nature of projects in hand, the margin profile of the company keeps on fluctuating. Due to the fragmented nature of the industry, project margins are generally dependent upon the level of competition in a particular segment, which in turn is dependent upon the level of expertise required to execute such projects. For instance, power projects involve higher margins as compared to road projects, since the execution of the former involves greater expertise.

Construction cost: Since projects are bid on cost estimations, any increase in price of inputs will have a direct impact on the company's profitability. On an average, material costs account for 45% to 50% of the operating cost of a construction company. Unprecedented rise in prices of key inputs like cement and steel might affect margins. Though most of the projects have price-escalation clause for increase in input cost, they are not sufficient to cover the incremental rise in prices. This is mainly due to the linking of the price-escalation clause with the wholesale price index (WPI). Therefore, if the rise in input cost is higher than the rise in WPI, the additional cost will have to be borne by the company. Contracts that include 'star price' on key materials like cement and steel is also becoming increasingly popular. In such contracts any increase/decrease in prices goes to client's account.

Key parameters for selecting a construction stock

For an average investor, size of the order book remains the sole criteria for investing in construction companies. More often than not, their decisions are based on order book to sales ratio of companies with little or no importance attached to the execution time and the margins of the projects. While order book to sales definitely gives an indication of visibility in growth of company's revenues, there are a few more things that investors need to consider before investing in stocks from the sector. These include:

Management:Though management is an important criterion for investment across the sectors, we believe that the same assumes greater significance in the construction industry considering the poor disclosure standards followed by the companies.

Segment presence:As mentioned earlier, the segment(s) in which a company operates has a direct impact on its revenues as well as profitability. Investors should invest in companies, which have expertise to execute diverse projects as also has the required skill-sets to execute projects with greater complexities (as these earn relatively better margins as compared to plain road construction type of projects).

Key ratio:Besides looking at order book to sales ratio, investors should focus on working capital to sales (considering high gestation period of projects), debt to equity, operating margins and return on capital employed ratios. Also, considering the huge amount of funding required for timely executing of projects, investors should also keep a check of the possible dilution in equity going forward.

Valuations: We believe that 'Price to earnings (P/E) ratio', is an appropriate metric for valuing construction companies. Besides, investors can also use 'Price to sales ratio (P/S) ratio' for valuation purpose. As we have explained earlier that order book should not be the sole criteria for looking at construction stocks, one should refrain from using some of the frivolous parameters like 'price to order book'.

Click here to identify stocks from other sectors.

Related Links for Construction Sector: Quarterly Results NEW | Sector Analysis Report | Sector Quote | Over The Years

Equitymaster requests your view! Post a comment on "Identifying a construction stock: Do's and don'ts". Click here!

1 Responses to "Identifying a construction stock: Do's and don'ts"


Oct 5, 2010

Dear Sir,
Sir i am not getting an idea to select the stocks as you have a very lenghthy proceedure and a detailed study for selecting the stock, can please help me to quot the stock in that i will be able to take the advancge of investing in equity masters

Equitymaster requests your view! Post a comment on "Identifying a construction stock: Do's and don'ts". Click here!

More Views on News

Mindspace Business Parks REIT IPO - Should You Apply? (IPO)

Jul 27, 2020

Should you apply for the IPO of Mindspace Business Parks REIT?

How Modi's Affordable Housing Focus is a Real Game Changer for the Economy (Views On News)

Jul 10, 2019

Government's push to affordable housing will revive the real estate sector.

More Views on News

Most Popular

It's the Beginning of a New Bull Phase in Smallcaps (Profit Hunter)

Feb 24, 2021

Last time the smallcap index crossed 19k a big correction followed. Here's what makes it different this time.

Make Rs 5,000 Per Day Trading the Market (Fast Profits Daily)

Feb 25, 2021

In this video, I'll show you how to get started on the path to daily trading profits.

The Hidden Tesla in My Great Indian Wealth Project (Profit Hunter)

Feb 23, 2021

An Indian company founded three decades ago in a garage caught my attention...

How Much Money For Day Trading? (Fast Profits Daily)

Feb 22, 2021

In this video, I'll show you how to allocate your capital as a day trader.


India's #1 Trader
Reveals His Secrets

Secret To Increasing Your Trading Profits Today
Get this Special Report,
The Secret to Increasing Your Trading Profits Today, Now!
We will never sell or rent your email id.
Please read our Terms


Mar 5, 2021 (Close)