Dropping capital efficiency

Insight

The Nifty has delivered a return of 386% to 4518.60 since the bull run started around April 2003. In the past one year, the index returned about 30%. Given this, it’s easy to think that almost all the stocks must have delivered.

But a study of 1,618 companies with a five-year track record shows that 64 have delivered negative returns of between (-)0.6% and (-) 90%.

One of the reasons for the underperformance could be the falling return on capital employed (ROCE) in the past four years for these companies.

ROCE measures the returns generated on total capital invested in percentage terms. Simply put, it is the amount earned by a company for every rupee invested in the business.

The ratio essentially measures the capital efficiency of a company. It is important specially to measure the profitability of capital-intensive industries such as power utilities, telecommunications and oil companies.

One simple reason for the falling ROCE could be that companies have diluted their equity or have taken loans on books to finance any future opportunities.

For example, Ranbaxy Laboratories has increased its total debt size by 576.19% to Rs 3,955.62 crore since 2003. Analysts say the debt is to take care of its future acquisition needs.

Another reason for the drop in ROCE could be the capex cycle of companies. Most companies are on an expansion spree currently given that India’s GDP is growing at around 9%. When companies forecast robust demand in future they draw up the expansion plans to cater to it.

It takes time for capacities to come on stream and generate revenues. When these capacities do come on stream, initially ROCE tends to rise. However, as soon as supply starts to surpass demand, the ratio starts to fall as oversupply results in a drop in prices.

For companies such as Kinetic Motor and TVS Motor — part of the 64 that posted negative returns — intense competition from peers has adversely affected the ROCE and stock price performance.

Hindustan Petroleum and Bharat Petroleum are reporting losses without subsidies, which is why their ROCE has registered a fall.

With no considerable hikes in petrol prices and government intervention have put pressure on operating margins a drop in ROCE. Any pressure in the margins is likely to reflect negatively in ROCE.

Analysts maintain that when a company’s revenues do not grow in sync with the costs then the ROCE gets adversely affected. ROCE generally deals with the pretax profits.

However, 27 companies out of 64 have shown negative profits in recent times and most of them have nil ROCE in that time. What this means largely is that lower revenues have resulted in the negative profits.

However, despite delivering negative returns, some companies have seen a growth in their ROCE in the course of five years. One among them is PCS technology; here the growth in ROCE can be attributed to the growth in revenues.

One of the major drawbacks of ROCE is that the assets of a business depreciate over a period of time. If the business is old, the ratio will thus look inflated. Precisely the reason why some of the older businesses deliver higher ROCE as compared to newer companies.

Also another hitch could be that inflation could lead to an increase in revenues but its not reflected in the capital invested by a company and in such cases the ratio could be misleading. All said and done ROCE remains one of the powerful tools to measure the profitability of a company.