• JULY 17, 2001

The importance of value creation

In the last few years the capital markets have witnessed major changes like the permission granted to Foreign institutional investors (FII) to invest in India, introduction of derivatives, ban on badla trading, trading in demat format (electronic form), e-broking, the setting up of a market regulator etc….

It saw the decline of UTI (Unit Trust of India) from its predominant position and the emergence of private sector players in the Indian mutual fund industry. In the last decade the Indian markets also witnessed many mini and mega scams and also participated in the global technology boom. With millions being made and lost in minutes, questions were abound in the minds of theoreticians and investors whether equity analysis is relevant and whether corporates take steps to create shareholder value and finally does the market punish companies that destroy shareholder value? I think equity analysis is important in at least identifying trends if not in timing of entry and exit prices. While there are some companies, which give importance to shareholder value, there is equal number of good corporates who took minority shareholders for granted and got punished in the process.

There are many methods of creating shareholder value but chief among them are created by:

  • Managements who have the vision to identify trends and invest in projects that generate positive net present value or

  • By managements who realize that they do not have adequate projects on hand to generate returns higher than they currently earn and therefore return the money in the form of higher dividend payout e.g. Hindustan Lever.

Alternatively shareholder value is destroyed by management who become obstinate and refuse to acknowledge change in trends or who react slowly to change in trends and by management who invest shareholders money in projects for which they are not adequately geared to handle.

Some of the listed automobile companies in India clearly bring out these issues. The following table shows the return generated by these companies and also the operating margins. You can also see how the market cap of the company declined in these years.

Avg ROE 28 24 22 21 18 -
OPM 16 15 15 13 5 -
Avg Market cap (Rs bn) 61 63 69 53 31 24
Avg ROE 25 8 3 2 (14) -
OPM 17 11 8 6 5 -
Avg Market cap (Rs bn) 116 82 52 60 26 18
Hero Honda
Avg ROE 44 46 49 52 47 -
OPM 9 11 12 13 14 -
Avg Market cap (Rs bn) 6 12 25 42 40 30
TVS Suzuki
Avg ROE 51 44 38 31 20 -
OPM 12 12 11 11 7 -
Avg Market cap (Rs bn) 4 8 10 11 7 2
* Based on current market price

Bajaj not only failed in identifying the trend against scooters, but also refused to take a decision on the huge amount of cash and investments it was holding in its balance sheet. The cash and investments that formed nearly 60% to 70% of balance sheet value was earning sub optimal returns. Belying the trust placed on the management, large part of the cash was also used to speculate in the stock markets. Result: Decline in shareholder value and decline in market cap.

Telco followed a different path that was quite opposite to what Bajaj did. It used the surplus and had to raise more money to invest in a project (the car project) whose returns were lower than what it was already earning. Hence for every incremental rupee it invested in the new project it was actually earning less than it was earning in its main commercial vehicle business. Agreed that the company might not have invested in these projects with any malafide intentions, but it clearly did not do its homework thoroughly and paid little respect to the advice of its well wishers. Result: Decline in shareholder value and decline in market cap.

TVS Suzuki probably got carried away with its own success and consequently suffered from blurred vision. The management failed to introduce 4 stroke vehicles in time to meet the requirement of changing environmental norms. Result it lost market share and also market cap.

Hero Honda is the only company that appears to have taken shareholders value seriously. It has improved its returns as well as margins. It however suffers from a peculiar problem currently, as Honda, its JV partner and global leader, has set up a 100% subsidiary. Consequently, markets are worried that the future cream lies in that subsidiary and not in Hero Honda. Result: A cap on market cap.

Will they change their ways?
Having seen the decline in market cap one only hopes that these companies learn from their mistakes and take value creation more seriously. The hope arises, as these are not some fly by night promoters, but promoters who have painstakingly established their name over many years of diligence.

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