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Return on Capital Employed and share price: Part II - Views on News from Equitymaster
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  • Oct 8, 2012

    Return on Capital Employed and share price: Part II

    In our first article we noted that if there was an increasing trend in RoCE for a particular company over a long period, the stock price also exhibited an increasing trend during that period.

    This article focuses on exploring whether the stock market punishes companies by pulling down their share prices if they continue to exhibit declining RoCEs' over the years.

    Return on Capital Employed (RoCE):

    RoCE is a measure of how effectively a company is able to deploy its capital base (debt and equity) to generate returns for the capital providers. A company which can generate higher return from a lower capital base and continues to improve on the same, should in theory, always be preferred over its peers which need higher capital to generate the same level of return and which cannot sustain the growth in RoCE. In the same vein, a company which exhibits a declining trend in RoCE over the years should encourage investors to withdraw their investments, resulting in a fall in the share price of the company.

    Three companies with decreasing RoCE trends from different sectors:

    To test the above hypothesis, we analyzed three companies from different sectors with dissimilar market capitalizations and with decreasing RoCE trends for the period FY07 to FY12.

    The companies that we selected are Unitech Ltd, Videocon Industries Ltd and Career Point Ltd.

    A very brief description of each of the above companies is as follows:

    Unitech Ltd: Unitech Ltd is a real estate developer engaged in residential, commercial, retail and hospitality projects. It also entered into a telecom joint-venture with Norway's Telenor to make inroads into the telecom sector in India. As of October 4, 2012, Unitech's market cap stood at Rs 68bn.

    Videocon Industries Ltd: Videocon Industries is engaged in the manufacturing of electronics and consumer durable items such as televisions and refrigerators. It also has stakes in oil fields in Africa and South America. As of October 4, 2012, its market cap stood at Rs 57bn.

    Career Point Ltd: Career Point is an education company headquartered at Kota, Rajasthan. It is in the businesses of tutorial services, education consultancy and management services, assessment and online testing services and infrastructure support services to educational institutions. As of October 4, 2012, its market cap stood at Rs 3bn.

    Table 1: Key parameters for Unitech, Videocon and Career Point for the period FY07 to FY12
      Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 CAGR(07-12)
    Gross Sales 32951 41195 28936 29316 34014 24296 -5%
    PBIT 19569 23848 20311 11224 10171 4944 -20%
    Capital Employed 76113 140659 160174 182035 176336 169876 14%
    ROCE 43% 22% 14% 7% 6% 3%  
    PBIT Margin 59% 58% 70% 38% 30% 20%  
      Sep-06 Sep-07 Sep-08 Sep-09 Dec-10 Dec-11 CAGR(06-11)
    Gross Sales 129634 125971 122371 106737 150287 136845 1%
    PBIT 12464 14196 17198 13860 11927 4513 -16%
    Capital Employed 118273 140259 190172 194517 232897 351072 20%
    ROCE 13% 11% 10% 7% 6% 2%  
    PBIT Margin 10% 11% 14% 13% 8% 3%  
      Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 CAGR(07-12)
    Gross Sales 291 380 452 617 786 796 18%
    PBIT 181 233 237 274 351 426 15%
    Capital Employed 253 421 623 1326 2656 2954 51%
    ROCE 72% 69% 45% 28% 18% 15%  
    PBIT Margin 62% 61% 53% 44% 45% 54%  
    Note: Videocon followed a September year end between 2006 and 2009 and a calendar year from 2010 onwards.
    Source: Ace Equity

    We observe from the above table that gross sales showed a steady declining trend at a compounded annual growth rate (CAGR) of 5% for Unitech Ltd between March07 and March12; given the high level of fixed operating cost, the Profit Before Interest and Tax (PBIT) fell disproportionately at a CAGR of 20% during the same period.

    Videocon Industries confronted a similar situation and witnessed growth in gross sales at a 1% CAGR between September06 and December11, while its PBIT fell at a CAGR of 16% during the same period.

    Career Point presented a completely different picture vis-c-vis Unitech and Videocon in the sense that its gross sales and PBIT increased at a CAGR of 18% and 15% respectively between March07 and March 12. And although its PBIT margin fell by 8%, it remained well above the 50% mark, which can be considered quite healthy.

    The commonality across the three companies is the disproportionate increase in Capital Employed (CE) as compared to the growth of gross sales and PBIT. While Career Point invested substantially in its business at a CAGR of 51% during FY07 and FY12, Unitech's and Videocon's CEs' increased at a CAGR of 14% and 20% respectively during our period of study.

    In our first article, we noted that in the case of Titan Industries, Bata India and Solar Industries, the increase in PBIT was at a faster pace than the increase in CE, which in turn resulted in higher RoCE's for each of them.

    However, in this article, Unitech, Videocon and Career Point present a polar opposite picture as their CEs' increased at a faster pace compared to their PBITs'. That in turn resulted in the drastic deterioration of their corresponding RoCEs' from 43%, 13% and 72% respectively at the beginning of our study period, to 3%, 2% and 15% respectively at the end of our study period.

    Share price performances of Unitech, Videocon Industries and Career Point:

    The following table presents the FY07 to FY12 period end share prices for Unitech, Videocon and Career Point.

    Table2: Share price performances of Unitech, Videocon and Career Point from FY07 to FY12
      Share Prices Share Price Growth Growth in Nifty50
      FY07 FY08 FY09 FY10 FY11 FY12 FY07-FY12 FY07-FY12
    Unitech 193.7 276.2 34.9 73.6 40.4 28.8 -85% 38%
    Videocon 407.8 370.6 195.4 251.2 216.7 174.4 -57%
    Career Point NA NA NA 470.5 331.1 194.6 -59%
    Source: Ace Equity

    Note: Between 2006 and 2009, September end prices are shown for Videocon and from 2010 onwards its share prices are as of December end. Career Point's FY10 share price is as of 29/10/2010 when it got listed and from FY11 onwards its share prices are as of March end. Growth in Nifty is from March 2007 to March2012.

    The above table clearly shows the abysmal share price declines of 85%, 57% and 59% for Unitech, Videocon and Career Point respectively vis-c-vis a 38% growth in Nifty50 between FY07 and FY12.


    Our analysis clearly reveals that an investor loses money by investing in the shares of companies with a declining RoCE trend. In fact, even if a company maintains a superior PBIT margin, and continues to grow its sales and PBIT as seen in the case of Career Point, its share price takes a beating in the long run, if the growth in investment (CE) outpaces the growth in PBIT.

    Thus, investors can certainly make valuable inferences from RoCE trends with regard to share prices of companies.

    However, as indicated in our first article on this topic, RoCE is just one of the parameters that an investor should keep in mind while picking stocks. Due consideration should be given to other valuation metrics like the Price to Earnings (P/E) ratio and the Enterprise Value to Earnings before interest, tax, depreciation and amortization (EV/EBITDA) ratio on trailing and prospective bases along with the company's ability to service its debt ( interest and principal) in the future.



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