February 2020
Company name
Thematic - RoE
A Root and Branch Analysis
Research Analyst: Sandeep Gupta
(S.Gupta@MotilalOswal.com); +91 22 6129 1551
Umesh Jain
(Umesh.Jain@MotilalOswal.com)
|
Aayush Heda
(Aayush.Heda@MotilalOswal.com)
10 December 2010
1
Investors are advised to refer through important disclosures made at the last page of the Research Report.
Motilal Oswal research is available on www.motilaloswal.com/Institutional-Equities, Bloomberg, Thomson Reuters, Factset and S&P Capital.
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Contents: A Root and Branch Analysis
A Root and Branch Analysis .................................................................................................. 3
RoE journey over 34 years .................................................................................................... 6
RoE – comprehensive 16-year trend ..................................................................................... 7
Cyclical sectors – key driver of India Inc. RoE ...................................................................... 10
PSU-private RoE at par but valuations vary ......................................................................... 18
High RoE desirable; improving RoEs key for market cap creation ....................................... 21
Capital structure-led RoE improvement uplifts valuations .................................................. 24
CASE STUDY 1: TCS .............................................................................................................. 25
CASE STUDY 2: ITC .............................................................................................................. 26
CASE STUDY 3: HINDUSTAN ZINC ........................................................................................ 27
Mid-caps: Lower RoE but outperformance to large-caps..................................................... 28
Improving RoE and PAT growth – a lethal combination ...................................................... 31
RoE ex-goodwill: Not a good comparable yardstick ............................................................ 34
Can a change in accounting treatment materially impact return ratios? YES! ..................... 35
Divergent trend of sectoral RoE: 2015-2019 ........................................................................ 36
Rising era followed by downward era ................................................................................. 39
Sector-wise DuPont analysis over the years ........................................................................ 41
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
India Inc. RoE
A Root and Branch Analysis
Return on equity (RoE) is one of the key strategic metrics used to evaluate the
capital allocation efficiency of a company. In this report, we present a detailed
study of how RoE has changed over time for India Inc, identify the factors driving
this change and its role in market cap creation. As widely known, India Inc’s RoE
has undergone two phases over the last 16 years (FY03-19): (1) ‘The Rising Phase’
over FY03-08, where this ratio for BSE500 hit a high of 22.9% (in FY07) and (2) ‘The
Downward Phase’ over FY08-19, where the ratio halved to its lowest level of 9.5%.
That said, we note that RoEs of India Inc. – excluding public sector banks (PSBs),
telecom and autos – have already showed signs of an improvement since FY15 (up
150bp to 14.0% in FY19 from a decade-low of 12.5% in FY15). This could further
gain steam with a revival in PSBs/telecom/autos and realization of corporate tax
rate cut benefits.
Our ‘root and branch’ study of India Inc RoE reveals some interesting insights: (a)
Cyclical sectors are key drivers of India Inc. RoE. (b) PSUs’ RoEs have remained at
par with their private counterparts, but their valuation multiples have remained
low. (c) A high RoE is desirable, but an improvement in it is key for market cap
creation. (d) Mid-caps have a relatively low (v/s large-caps) but highly variable
RoE, which leads to its outperformance versus large-caps. (e) Capital structure-led
RoE improvement uplifts valuation multiple. (f) Improving RoE and earnings
growth is a lethal combination for market cap creation.
FY03-FY08
THE RISING
PHASE
THE
RECOVERY
PHASE
RoE PHASES
OVER PERIOD
THE
DOWNWARD
PHASE
FY15-FY19
FY08-FY19
Cyclical sectors – key driver of India Inc. RoE
Cyclical sectors command a dominant weight in the index profit and net worth
pool, with global cyclicals being the major contributor to index RoE in 11 of the
last 16 years. As a result, RoEs have trended up/down in phases or rather cycles.
Over FY03-19, the cyclical sectors of Oil & Gas/Metals contributed ~30% of the
cumulative profit pool and ~24% of incremental net worth. However, annual
contribution of these sectors to the overall profit pool has fluctuated in a wide
range of 18%-42%.
Our DuPont analysis suggests that since cyclical sectors are the key drivers to
India Inc’s RoE, over both the phases RoE was more sensitive to the NP margins
(from 8.8% to 11.4% – 29.4% variance – in the rising phase, and from 11.4% to
5.5% – around 51.5% variance – in the downward phase) than asset turns (from
0.41x to 0.48x – 17.9% variance – in the rising phase, and from 0.48x to 0.35x –
around 26.0% variance – in the downward phase).
Financial leverage as commonly understood works in the reverse direction of
the cycle (falls in the rising phase and increases in the downward phase).
Average core RoE of India Inc (defensives) for the last 16 years stands at a
robust 21.1%, mainly driven by the Consumer (average RoE: 30.9%) and
Technology (30.6%) sectors.
February 2020
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Thematic | India Inc. RoE
PSU-private at par on RoE, but valuations vary
RoE of PSUs (ex BFSI) has remained largely in line with that of their private
sector counterparts (ex BFSI). It stood at 15.4% for PSUs and 12.7% for private
sector in FY19.
However, we note of a significant divergence between the P/E multiples of
these sectors. As at end-FY19, PSUs (ex BFSI) traded at a P/E multiple of 9.4x, as
against 28.6x for private sector (ex BFSI), marking a discount of ~67%.
Apart from regulatory headwinds and continuous stake sale by the government
through divestments, the other two factors driving this valuation divergence
were: (i) the higher share of earnings contribution from cyclical businesses and
(ii) the lower earnings growth expectation.
High RoE desirable but improving RoEs key for market cap creation
Evidently, companies with high RoEs trade at premium valuations. However, we
note that markets are usually quick to factor in such high RoEs in the price. This
is corroborated by our analysis of BSE200 companies which revealed mixed
performances in terms of market cap creation by high-RoE companies v/s low-
RoE companies (outperformance/underperformance: CAGR of -1% to +4%) over
the three tested cycles (FY03-08, FY08-13 and FY13-19).
Interestingly, our analysis highlighted that the change in RoE has a material
impact on market cap creation. Companies with improving RoE have
significantly outperformed (CAGR of 7% to 17%) those with declining RoE over
the three tested period.
Capital structure-led RoE improvement uplifts valuation multiples
RoEs of companies can be improved either by accelerating earnings momentum
(numerator) or employing a superior capital allocation strategy (denominator).
Our hypothesis is that cash-rich companies can optimize their capital allocation
by increasing payouts (of surplus cash) to shareholders and in turn achieve
better RoEs/valuation multiples. This is confirmed by our case studies on TCS,
ITC and Hindustan Zinc – these companies garnered better valuation multiples
by improving RoE led by step-up in shareholder payouts (dividends/buybacks).
Midcaps: Lower RoE but outperformance to large caps
The underperformance of midcaps vis-à-vis large caps since FY17 is well known.
However, an analysis of the last 10-year performance reveals that the
performance of both the Nifty and the Nifty Midcap 100 has been cyclical, with
the latter outperforming from a longer-term perspective.
Over the three tested cycles (FY03-08, FY08-13 and FY13-19), mid-cap
companies (excl. BFSI) have outperformed large-caps in market cap creation
(percentage wise) by a significant margin. This is despite lower RoEs of mid-caps
than large-caps in all the three tested cycles. This, in our view, is primarily on
account of higher earnings growth and thus higher variability (improvement) in
RoEs for mid-caps.
Improving RoE and PAT growth – a lethal combination
Companies with 'improving RoE' and 'earnings growth' are the best for market
cap creation. Our analysis of BSE500 companies over two phases (from FY08-13
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
and FY13-19) reveals that companies with both improving RoE and earnings are
ideal for generating best returns, while those with declining RoE/earnings
growth have delivered the weakest market cap returns.
Based on the above hypothesis, our top picks within the MOFSL coverage
universe are:
Large-caps:
Axis Bank, Bharti Airtel, Hindustan Unilever, Infosys and
Ultratech Cement.
Mid-caps:
Federal Bank, JSW Energy, Tata Global, Trent and Voltas.
Note that we have taken an improvement of 20% in both RoE (estimated for
FY22 over the median of FY16-20) and relative PAT growth (CAGR over FY20-22E
v/s CAGR over FY16-20) as a threshold level.
KEY FINDINGS FROM THE STUDY
Cyclical sectors have a dominant
weight in index profit and net worth
pool. Thus, India Inc. RoE has
moved up/down in cycles.
RoE of PSUs (excluding BFSI) has
been in line with that of private
sector counterparts. However, a
valuation divergence exists.
High-RoE companies are desirable
and trade at premium valuation.
However, improving RoE companies
are key for market cap creation.
Cash-rich companies can improve
their RoE by increasing earnings
payout, which, in turn, would uplift
valuation multiple.
Mid-cap companies have
outperformed large-cap despite lower
RoE in three tested cycles over FY03-
19. This is due to high PAT growth and
RoE variability.
Companies with improving RoE and
PAT growth are best for market cap.
creation.
February 2020
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 Motilal Oswal Financial Services
ROE JOURNEY OVER 34 YEARS
9
1986:
16.3%
1987:
17.4%
1988:
15.7%
1989:
14.4%
1990:
13.7%
1991:
13.0%
1992:
13.1%
1993:
10.9%
1994:
12.2%
1995:
14.1%
1996:
15.6%
1986-90
PRE-LIBERALISATION
ADJUSTING TO THE NEW
WAVE OF LIBERALISATION
1997:
14.2%
2006:
20.4%
2007:
22.9%
2008:
22.7%
2005:
21.6%
2004:
19.8%
ECONOMIC SLOWDOWN
1999-03
2003:
16.8%
2002:
13.4%
2001:
13.6%
2000:
13.1%
1999:
12.3%
1998:
14.4%
1991-98
DREAM RUN GROWTH
2004-08
2009:
16.2%
2010:
18.1%
HIGH GROWTH LED BY RISING
ECONOMIC IMBALANCES
ECONOMIC ADJUSTMENT
UNDER NEW LEADERSHIP
ECONOMIC SLOWDOWN
2011:
18.0%
2009-13
2012:
15.8%
2013:
14.7%
2014:
14.0%
2015:
12.2%
2016:
10.9%
2017:
11.8%
2018:
10.2%
2014-18
2019: 9.5%
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
RoE – comprehensive 16-year trend
Signs of recovery post FY15
RoEs for India Inc. have undergone two phases over the last 16 years: (1) ‘The Rising
Phase’ over FY03-08, where this ratio for BSE 500 companies hit a high of 22.9% (in
FY07) and (2) ‘The Downward Phase’ over FY08-19, where the ratio halved to 9.5%.
Our study reveals that the RoEs of Corporate India – excluding public sector banks
(PSBs), Telecom and Autos – have already showed signs of an improvement from FY15
(up 150bp to 14.0% in FY19 from the decade’s low of 12.5% in FY15).
This could gain further steam as (a) PSBs begin reporting improved financials off a low
base (which was created due to the cleaning up of their balance sheets by providing
for NPAs), (b) the telecom sector gains strength led by easing competitive intensity
and rising ARPUs, (c) auto sector sluggishness eases out post implementation of BS-VI
norms and (d) the corporate tax cut announced in FY20 is also going to boost the
earnings and hence RoEs for most companies.
RoE of BSE500 companies at 16-year low
RoE of BSE500 moved up from 16.8% in FY03 to a high of 22.9% in FY07 but
trended down after the financial crisis of 2008 due to a slew of macro and
microeconomic factors. It stood at 9.5% in FY19 – lowest in last 16 years.
Our DuPont analysis reveals a decline in both profit margins (at 5.5% v/s 8.8% in
FY03) and asset turns (at 0.35x v/s 0.41x in FY03). However, rising financial
leverage multiples (4.88x v/s 4.17x in FY03) provided some support to RoE.
Exhibit 1: BSE500 RoE at 16-year low (%)
19.8
16.8
21.6
22.9 22.7
20.4
16.2
18.1 18.0
15.8
14.7 14.0
12.2
11.8
India Inc. RoE’s have
mimicked the NP margin
trend over the last 16 years
10.9
10.2 9.5
Source: Capitaline, MOFSL
Exhibit 2: NP margin of BSE500 companies contracts post FY08
(%)
10.5
8.8
11.0
10.5
11.3 11.4
8.3
10.3 10.0
8.0
7.5
7.2
6.6
6.7
7.2
6.2
5.5
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 3: Asset turns decline gradually after FY08 (x)
Asset Turnover
Exhibit 4: Leverage shows inverse correlation to RoE (x)
Equity Multiplier
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Understanding RoE cycles: Diverging sectoral RoE post FY15
RoE of corporate India Inc.
is at a 16-year low of 9.5%;
however, India Inc.
excluding PSBs, Telecom
and Auto has already
showed signs of
improvement post FY15.
RoE has trended up/down in cycles over the last 16 years. After moving up from
FY03 to FY07 (+590bp to 22.9%), it has headed down post the financial crisis of
2008 (-1,320bp to 9.5% in FY19).
In the recent past, RoE has been largely impacted by high NPA
provisioning/write offs made by PSBs, intensifying competition in the telecom
sector and shrinking margins in the auto sector. However, excluding PSBs,
telecom and auto, the ratio has showed signs of a recovery in recent years (up
150bp to 14.0% in FY19 from a low of 12.5% in FY15; refer annexure no. 1 for
details).
To better understand RoE, we categorize the trend over the last 16 years into
two separate periods: (i) the rising trend from FY03-08 and (II) the downward
trend from FY08-19, albeit with signs of a recovery in a few sectors.
Based on 16-year trend of RoE, we draw following conclusions:
Cyclical sectors – the key driver of India Inc. RoE
PSU-private at par on RoE, but valuations vary
High RoE desirable, but improving RoEs is the key for market cap creation
Capital structure-led RoE improvement uplifts valuation multiples
Mid-caps: Lower RoE but outperformance versus large-caps
Improving RoE and PAT growth – a lethal combination for market cap creation
February 2020
8
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
SECTORAL TREND OF ROE
AUTO
FY03
FY08
FY19
%
14.1
25.3
3.6
BANKS
PVT
FY03
FY08
FY19
%
17.5
13.1
9.7
BANKS
PSU
FY03
FY08
FY19
%
20.6
17.1
-10.9
CAP
GOODS
FY03
FY08
FY19
%
14.1
28.2
16.4
CEMENT
FY03
FY08
FY19
%
3.2
39.2
9.8
Consumer
FY03
FY08
FY19
%
28.1
37.1
24.9
PHARMA
FY03
FY08
FY19
%
24.5
26.7
11.3
INFRA
FY03
FY08
FY19
%
13.8
13.7
-10.2
SECTORAL TREND OF ROE
MEDIA
FY03
FY08
FY19
%
7.2
8.4
8.6
METALS
FY03
FY08
FY19
%
9.1
36.1
16.2
NBFC
FY03
FY08
FY19
%
15.1
19.9
14.7
OIL
& GAS
FY03
FY08
FY19
%
26.1
24.1
13.9
RETAIL
FY03
FY08
FY19
%
12.7
38.4
15.9
IT
FY03
FY08
FY19
%
23.8
34.0
26.0
TELE-
COM
FY03
FY08
FY19
%
-1.4
23.7
-18.1
UTILITIES
FY03
FY08
FY19
%
10.2
11.7
8.4
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CONCLUSION 1
Cyclical sectors – key driver of India Inc. RoE
High aggregate profit pool of cyclical sectors drives variability
Cyclical sectors command a dominant weight in the index profit and net worth pool,
with global cyclicals being the major contributor to index RoE in 11 of the last 16
years. As a result, RoEs have trended up/down in phases or rather cycles.
Cyclical sectors have a
dominant weight in
the index profit and
net worth pool. Thus,
India Inc. RoE has
moved up/down in
cycles.
Over FY03-19, the cyclical sectors of Oil & Gas/Metals contributed ~30% of the
cumulative profit pool and ~24% of incremental net worth. However, annual
contribution of these sectors to the overall profit pool has fluctuated in a wide range
of 18%-42%.
Our DuPont analysis suggests that since cyclical sectors are key drivers to India Inc’s
RoE, over both the phases RoE was more sensitive to the NP margins (from 8.8%
to 11.4% – 29.4% variance – in the rising phase, and from 11.4% to 5.5% – around
51.5% variance – in the downward phase) than asset turns (from 0.41x to 0.48x –
17.9% variance – in the rising phase, and from 0.48x to 0.35x – around 26.0% variance
– in the downward phase).
Financial leverage as commonly understood works in the reverse direction of the cycle
(falls in the rising phase and increases in the downward phase).
Average core RoE of India Inc (defensives) for the last 16 years stands at a robust
21.1%, mainly driven by the Consumer (average RoE: 30.9%) and Technology (30.6%)
sectors.
Consumer/Tech – highest RoE but low contribution to aggregate profit pool
Over FY03-19,
Consumer/Tech companies’
average index profit
contribution remained low
at 5.5%/10.9%; Oil & Gas
was an outlier with profit
contribution of 20.0%
We have attempted to plot the sectors’ 16-year average profit and net worth
weights on the x- and y-axis, and their RoEs on the z-axis of the bubble chart in
order to obtain relative insight into the sectors’ RoE and their contribution to
overall index RoE.
Consumer and technology companies command high RoE, given their asset-light
model and consequent low capital intensity. Despite this, their contribution to
index RoE has remained low.
On the other hand, lower-RoE sectors such as oil & gas, PSBs, metals and utilities
contribute significantly to index RoE. Oil & gas contributed the highest at 20% of
the cumulative profit pool and 16% of net worth accretion. Separately, metals
contributed 10% of the cumulative profit pool and 8% of net worth accretion.
We note that sectors with a higher contribution to the profit pool than to net
worth accretion have led to their positive RoE contribution.
In the recent past, BFSI has contributed significantly to net worth accretion.
However, the sector’s contribution to the profit pool has come down due to
balance sheet clean-up (higher among PSBs), dragging down overall index RoE.
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 5: Oil & Gas – biggest contributor to index profit/net worth pool (avg. RoE: FY03-19)
20.0%
Oil & Gas
15.0%
Banks - PSU
10.0%
Banks - Pvt
Utilities
Capital Goods
NBFC
Metals
5.0%
Healthcare
Automobiles
Technology
Consumer
0.0%
0.0%
5.0%
10.0%
PROFIT WEIGHT IN INDEX
Size of bubble represents average RoE over FY03-19
Source: Capitaline, MOFSL
15.0%
20.0%
Exhibit 6: Cyclical sectors contribute significantly to profit pool of BSE500
Cumulative NP over FY03-19 (INR t)
10.7
5.8
5.5
4.5
3.8
3.6
3.2
3.0
2.4
2.3
2.3
1.7
1.0
0.9
0.7
0.6
0.6
0.4
0.3
0.2
0.1
0.0
Source: Capitaline, MOFSL
Exhibit 7: Low relative addition of net worth by global cyclicals
Net Worth Contributor over FY03-19 (INR t)
2.4
2.2
1.7
1.6
1.5
1.2
0.9
0.8
0.8
0.7
0.6
0.3
0.2
0.2
0.1
4.5
7.9
6.0
5.1
4.7
3.9
3.1
2.9
53.2
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 8: Most sectors achieved high RoE in FY08 (%)
39
25
14
4
2117
18
1310
28
14 16
3
10
FY03
37
28 25 2527
11
5 7
13
7 8 9 9
FY08
FY19
36
34
2624
24 26
20
16 15 15
14 13 16
38
24
23
17
1012 8
10
-11
-1
-18
Source: Capitaline, MOFSL
Cyclicals – key RoE determinant across phases
Cyclical sectors continue
driving index RoE; global
cyclicals were the biggest
contributor to index RoE in
11 of the last 16 years.
Over FY03-19, the index RoE exhibited two phases – rising from 16.8% in FY03 to
22.7% in FY08 and thereafter declining to 9.5% in FY19. This trend was primarily
driven by the underlying heavyweight sectors of global cyclicals – oil & gas and
metals. (refer annexure 2 for details)
Cyclical sectors continue driving the trend of index RoE – global cyclicals (oil &
gas and metals) dominated with a contribution of ~30% of BSE500 RoE over
FY03-19 and a 90% RoE co-relation with BSE500. Domestic cyclicals (ex. BFSI)
also contributed a significant ~26% of BSE500 RoE with an 85% co-relation.
Global cyclicals were the biggest contributor to index RoE for 11 of the 16 years
under study. Also, they were the primary factor behind: (a) the sharp decline in
RoE in FY09 and (b) the recovery in RoE (excluding PSBs, auto and telecom) post
FY15.
BFSI contributed the highest to index RoE for three (FY13-15) of the 16 years
under study. However, asset quality review took a toll on earnings of PSBs in
FY16.
The obvious analogy for this is derived from the fact that global cyclicals (oil &
gas and metals) contributed the highest to the BSE500 cumulative profit pool
and net worth accumulation.
Exhibit 9: Index RoE mimics trend of global cyclicals (%)
Global Cyclical
19.8
16.8
4.5
2.3
3.1
6.9
FY03
4.8
2.7
4.1
8.2
FY04
21.6
4.2
3.4
4.8
9.2
FY05
20.4
4.1
3.3
4.8
8.2
FY06
22.9
4.2
5.0
4.9
8.8
FY07
22.7
4.2
4.8
5.1
8.6
FY08
16.2
3.7
4.0
3.5
5.0
FY09
18.1
4.0
4.0
4.1
5.9
FY10
18.0
4.1
4.0
4.4
5.6
FY11
15.8
4.0
3.3
3.8
4.7
FY12
Domestic Cyclicals
Defensive
BFSI
BSE 500
14.7
4.4
3.5
3.3
3.5
FY13
14.0
3.8
3.7
2.8
3.8
FY14
12.2
3.8
3.8
2.5
2.2
FY15
10.9
2.1
3.7
2.9
2.2
FY16
11.8
2.3
3.6
2.8
3.1
FY17
10.2
0.6
2.6
3.2
3.7
FY18
9.5
1.1
2.8
2.0
3.6
FY19
*Domestic cyclical excludes BFSI
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 10: Global cyclicals – major RoE contributor in 11 of 16 years
Global Cyclical
27
14
18
41
FY03
24
13
21
41
FY04
20
16
22
42
FY05
20
16
24
40
FY06
18
22
21
38
FY07
18
21
23
38
FY08
23
25
22
31
FY09
Domestic Cyclicals
22
22
23
33
FY10
23
22
24
31
FY11
25
21
24
30
FY12
Defensive
30
24
22
24
FY13
27
26
20
27
FY14
BFSI
31
31
20
18
FY15
20
34
27
20
FY16
19
31
32
23
27
FY17
36
FY18
6
26
12
30
21
38
FY19
Source: Capitaline, MOFSL
Exhibit 11: Global cyclicals’ RoE exhibits high correlation…
90%
Co-relation with BSE 500 RoE
85%
82%
80%
Exhibit 12: …with index RoE (%)
Global Cyclical
30.0
25.0
20.0
15.0
10.0
5.0
BSE 500
BSE500 Ex PSB
Global Cyclical
Domestic
Cyclicals
Defensive
BFSI
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Exhibit 13: India core RoE 16-year average robust at 21.1%
36.0
28.0
20.0
12.0
4.0
Cyclicals RoE
India Core RoE
BSE500
*Cyclical includes BFSI
Source: Capitaline, MOFSL
RoE =
PAT/Revenue*Revenue/Asset*
Asset/Net worth
RoE shows highest sensitivity to NP margins
RoE is highly sensitive to NP
margin followed by asset
turnover.
Since cyclicals drive the index level RoEs, India Inc.'s RoE is most sensitive to NP
margins, followed by asset turns.
According to our DuPont analysis, the three primary drivers of RoE are better
asset turnover, improved margins and higher debt levels.
Our analysis reveals that profit margin variability was a major factor driving the
RoE trend in both the phases. During the rising phase of 2003-08 when RoE
increased by 590bp to 22.7%, the NP margin improved by 260bp to 11.4%.
February 2020
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Similarly, during the downcycle of 2008-19 when RoE declined to 9.5% (FY08:
22.7%), the NP margin shrank to 5.5% (FY08: 11.4%). In order to gain more
insights, we have delved further into each RoE cycle.
Rising Era: 2003-2008 – NP margin expansion drives RoE improvement
BSE 500 RoE increased by
590bp to 22.7% in FY08, led
by expansion in NP margin
(11.4% in FY08 v/s 8.8% in
FY03).
BSE500 RoE increased from 16.8% in FY03 to 22.7% in FY08, led by expansion in
the NP margin (11.4% in FY08 v/s 8.8% in FY03) and asset turns (0.48x in FY08
v/s 0.41x in FY03). Rising profitability and asset turns led to a decline in debt,
leading to a reduction in financial leverage from 4.71x in FY03 to 4.17x in FY08.
Under our DuPont analysis, the three parameters are measured in different
terms – i.e. NP margins (%) and asset turn and financial leverage (x times) – and
are thus not comparable. We have attempted to standardize the three factors
of DuPont in percentage terms to facilitate comparability.
During FY03-08, the NP margin improved by 29.4% to 11.4% in FY08 (FY03:
8.8%); while the asset turnover improved by 17.9% to0.48x (FY03: 0.41x),
leading to healthy free cash flow generation & facilitating deleveraging. The
financial leverage declined by 11.4% to 4.17x (FY03: 4.71x).
Exhibit 14: RoE up 590bp over FY03-08 (%)
22.9
21.6
19.8
20.4
22.7
16.8
FY03
FY04
FY05
FY06
FY07
FY08
Source: Capitaline, MOFSL
Exhibit 15: NP margins drive RoE improvement
Du-Pont
NP Margin %)
Asset Turn (x)
Financial Lev (x)
ROE (%)
FY03
8.8
0.41
4.71
16.8
FY04
10.5
0.41
4.58
19.8
FY05
11.0
0.44
4.51
21.6
FY06
10.5
0.44
4.38
20.4
FY07
11.3
0.47
4.29
22.9
FY08
11.4
0.48
4.17
22.7
Exhibit 16: DuPont
three matrix performance
BSE 500 (FY03-08)
29.4%
17.9%
-11.4%
Source: Capitaline, MOFSL
NP Margin
Asset Turnover
Financial Leverage
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
We performed a sensitivity analysis to understand the factors driving a
significant increase/decrease in RoE. Our sensitivity analysis reveals that a
change in the net profit margin has the greatest impact on RoE.
Exhibit 17: RoE most sensitive to NP margins
Over FY03-08, of the 22
broad sectors 19 witnessed
RoE improvement. Amongst
them, RoE of 8 sectors
improved due to NP
margins & 3 due to
improving asset turnover.
RoE of remaining sectors
improved due to
combination of multiple
factors.
Sector
Automobiles
Banks - Private Sector
Ban ks - Pubil c Sector
Capital Goods
Cement
Chemicals
Consumer
Divers ified
He althcare
Infrastr cture
Insurance
Me dia
Me tals
Misc
NBFC
Oil & G as
Real Estate
Retail
Technology
Telecom
Tex til es
Utilities
ROE
FY03-08
NP Margin
Asset turn.
↑↑
↑↑
↑↑
↑↑
↓↓
↑↑
↓↓
↑↑
↑↑
↑↑
↑↑
↑↑
↑↑
Fin. Leverage
↓↓
↓↓
Change in RoE due to the factor by specified percentage:
↔ - Neutral – positive and negative by less than 2%
↑ - Increase – Positive by more than 2% and less than 10%
↓ - Decrease – Negative by more than 2% and less than 10%
↑↑ - Factor leading the uptrend – Positive by more than 10%
↓↓ - Factor leading the downtrend – Negative by more than 10%
Source: Capitaline, MOFSL
Downtrend Era: 2008-2019 – NP margin contraction impacts RoE
Index RoE declined to a decadal low of 9.5% in FY19 from 22.7% in FY08. Our
analysis attributes this to a contraction in the profit margin (at 5.5% in FY19 v/s
11.4% in FY08) and asset turns (at 0.35x v/s 0.48x in FY08). However, rising
financial leverage multiples (at 4.88x v/s 4.17x in FY08) provided some support
to RoE.
Contracting profit margin was the major factor impacting RoE. Over FY08-19, NP
margin declined by 51.5% (to 5.5% in FY19), asset turns were down by 26.0% (to
0.35x in FY19) and financial leverage increased by 17.0% (to 4.88x in FY19).
February 2020
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 Motilal Oswal Financial Services
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Exhibit 18: BSE500 RoE declines to decade low (%)…
22.7
16.2
18.1
18.0
15.8
14.7
14.0
12.2
10.9
11.8
10.2
9.5
Source: Capitaline, MOFSL
Exhibit 19: …led by margin contraction (%)…
11.4
8.3
10.3 10.0
8.0
7.5 7.2
7.2
6.6 6.7
6.2
Exhibit 20: …and falling asset turns (x)
0.48
0.46
0.40 0.41
5.5
0.43
0.41
0.40
0.37
0.33 0.33 0.34
0.35
Exhibit 21: Rising financial leverage supports RoE (x)
4.73
4.82
4.90 4.94 4.91 4.89 4.88
Exhibit 22: DuPont
three matrix performance over a decade
BSE 500 (FY08-19)
17.0%
-26.0%
-51.5%
4.17
4.25
4.35 4.41
4.57
NP Margin
Source: Capitaline, MOFSL
Asset Turnover
Financial Leverage
Source: Capitaline, MOFSL
We performed a similar sensitivity analysis for the last 11 years. It reveals a
similar phenomenon where a change in the net profit margin had the greatest
impact on RoE.
February 2020
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Thematic | India Inc. RoE
Exhibit 23: RoE declines across sectors, led by NP margins
Over FY08-19, of the 22
broad sectors, 20 witnessed
an improvement in RoE.
Among these sectors, RoE
of 11 sectors declined due
to deteriorating NP margin
and that of four sectors on
account of a rise in asset
turns. RoE of the remaining
sectors improved because
of a combination of
multiple factors.
FY08-19
Sector
Automobiles
Banks – PVT
Banks - PSU
Capital Goods
Cement
Chemicals
Consumer
Diversified
Healthcare
Infrastructure
Insurance
Media
Metals
Misc
NB FC
Oil & Gas
Real Estate
Retail
Technology
Telecom
Textiles
Utilities
ROE
NP Margin
↓↓
↓↓
↓↓
↓↓
↓↓
↓↓
↓↓
↓↓
↓↓
Asset turn.
↓↓
↓↓
↓↓
↑↑
Fin. Leverage
↑↑
↓↓
Source: Capitaline, MOFSL
Change in ROE due to the factor by specified percentage:
↔ - Neutral – Positive and negative by less than 2%
↑ - Increase – Positive by more than 2% and less than 10%
↓ - Decrease – Negative by more than 2% and less than 10%
↑↑ - Factor leading the uptrend – positive by more than 10%
↓↓ - Factor leading the downtrend – negative by more than 10%
February 2020
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Thematic | India Inc. RoE
CONCLUSION 2:
PSU-private RoE at par but valuations vary
Higher earnings from cyclicals | Lower growth outlook for PSUs
2
RoEs of PSUs (excluding
BFSI) have been in line
with those of their private
sector counterparts.
However, a valuation
divergence
exists.
RoE of PSUs (ex BFSI) has remained largely in line with that of their private sector
counterparts (ex BFSI). It stood at 15.4% for PSUs and 12.7% for private sector in FY19.
However, we note of a significant divergence between the P/E multiples of these
sectors. As at end-FY19, PSUs (excl. BFSI) traded at a P/E multiple of 9.4x, as against
28.6x for private (excl. BFSI), marking a discount of ~67%.
Apart from regulatory headwinds and continuous stake sale by government through
divestments, the other two factors driving this valuation divergence were: (i) the
higher earnings contribution from cyclical businesses and (ii) the lower earnings
growth expectation.
RoE of PSUs (ex-BFSI) in line with private counterparts
Over the past few years, the
RoE of PSUs (excluding BFSI)
has converged with that of
their private sector
counterparts.
Over FY03-19, RoE of PSUs primarily trailed that of their private counterparts,
except for a few years when a cyclical trend boosted the RoE of PSUs quite
significantly.
Over the past few years, the gap between the RoEs of PSUs and their private
counterparts has widened significantly, with the difference in their RoEs (private
RoE minus PSU RoE) shooting up from 2 percentage point in FY15 (private RoE:
12.9%, PSU RoE: 10.9%) to more than double at 4.9 percentage point in FY19
(private RoE: 11.8%, PSU RoE: 6.9%). This widening of the gap was mainly due to
the underperformance of PSU banks.
However, if we look at the RoE excluding the BFSI segment, the trend is quite in
contrast to the prevailing general thesis.
Over the past few years (Exhibit 25), the RoE of PSUs (excluding BFSI) has
converged with that of their private sector counterparts. However, in FY19, PSU
RoE was higher at 15.4% compared with the private sector (12.7%).
Exhibit 25: Ex BFSI, PSU RoE in line with private
30.0%
22.5%
15.0%
7.5%
0.0%
Pvt RoE EX BFSI
PSU RoE EX BFSI
Exhibit 24: PSU banks pull down PSU RoE in FY18/19
30.0%
22.5%
15.0%
7.5%
0.0%
Pvt RoE
PSU RoE
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Significant P/E divergence due to cyclical business and lower growth
Over FY03-18, average P/E
discount of PSUs v/s private
counterparts has remained
at 40%.
PSU companies continue trading at a lower P/E multiple than their private
counterparts, primarily because: (a) most of the material PSU sector companies
have cyclical businesses, (b) lower expectation of growth, (c) regulatory risk and
(d) continuous divestments by government.
As on FY19, the PSU sector (excluding BFSI) traded at a P/E multiple of 9.4x as
against the private sector (excluding BFSI) at 28.6x, marking a discount of ~67%.
Average P/E discount of PSU companies was at 40% over FY03-19. Ex-BFSI, it
stood at 42%.
P/E discount over the years is partially attributable to the higher profit
contribution from cyclical businesses for PSU companies (78% over FY03-19)
than private counterparts (42%).
Profit CAGR for PSU companies was at 6.6% (Ex BFSI: 10.9%) over FY03-19 –
lower than 20.1% (ex BFSI: 19.6%) for private companies. This could be the
reason for a discount in the P/E multiples.
Exhibit 26: Losses of PSBs make P/E look optically high in
FY18
40.0
30.0
20.0
10.0
0.0
Pvt PE
PSU PE
Exhibit 27: Ex BFSI, PSU P/E at avg. ~42% discount to private
40.0
30.0
20.0
10.0
0.0
Pvt PE Ex BFSI
PSU Pe Ex BFSI
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Exhibit 28: ~78% of profit contributed by cyclicals for PSUs…
PSU profit cotribution over FY03-19
Exhibit 29: …while cyclical profit share for pvt. at 42%
Pvt profit cotribution over FY03-19
22%
0%
22%
BFSI
Defensive
Domestic Cyclicals
Global Cyclical
24%
18%
20%
BFSI
Defensive
Domestic Cyclicals
Global Cyclical
56%
INR 18.0tn
INR 34.3tn
39%
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 30: PSU net profit CAGR of 6.6%
PSU NP (INR tn)
1.3
0.7 0.7
0.9
1.0 1.0
1.4
1.5 1.6 1.5
Exhibit 31: Ex BFSI, PSU net profit CAGR of 10.9%
PSU NP Ex BFSI (INR tn)
1.4
0.9
0.7
0.3
1.3
1.1
0.4
0.5 0.5
0.7
0.9
0.6
0.9 1.0 1.0 1.0
0.8 0.9
1.4
1.2 1.2
0.8
0.4
0.6
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Exhibit 32: Private net profit CAGR of 20.1%
Pvt NP (INR tn)
2.7 2.6
3.1
3.6
3.9 4.0
Exhibit 33: Ex BFSI, private net profit CAGR of 19.6%
Pvt NP EX BFSI (INR tn)
1.9 1.8 1.7
2.1
2.4
1.9
3.2 3.1
2.7
0.3 0.3
0.6 0.7
1.1
1.6
1.3
1.8
2.2 2.2 2.3
1.4
0.2 0.3
0.5 0.6
1.0
1.2
1.6
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CONCLUSION 3
High RoE desirable; improving RoEs key for market cap
creation
Leads to rerating of valuation multiples
High RoE companies
are desirable and trade
at premium valuation.
However, improving
RoE companies are key
for MC creation
3
Evidently, companies with high RoEs trade at premium valuations. However, we note
that markets are usually quick to factor in such high RoEs in the price. This is
corroborated by our analysis of BSE200 companies which revealed mixed
performances in terms of market cap creation by high-RoE companies v/s low-RoE
companies (outperformance/underperformance: CAGR of -1% to +4%) over the three
tested cycles (FY03-08, FY08-13 and FY13-19).
Interestingly, our analysis highlighted that the change in RoE has a material impact on
market cap creation. Companies with improving RoE have significantly outperformed
(CAGR of 7% to 17%) than companies with declining RoEs over the tested period.
High RoE desirable but improving RoE key for market cap creation
Companies with high RoEs
trade at premium
valuations. However,
markets are usually quick to
factor in such high RoEs in
the price.
One key question while looking at RoE from a longer-term perspective is: which
company is best for higher wealth creation – one with a (absolute) high level of
RoE or one in the improving phase of RoE?
We believe that RoE of a company is one of the quantitative representations of
its competitive advantage (economic moat. A high RoE (v/s sector peers) thus
represents a significant competitive advantage and its relative
weakening/strengthening (v/s peers) represents weakening/strengthening of
the competitive advantage.
RoEs of companies vary materially within the sector they operate in. Thus,
comparing RoE of a company operating in one sector with that of a company
from another sector (say a consumer facing company that enjoys RoE in excess
of 50% v/s banks with RoE of 15-20%) may not bring out the right picture. In
order to classify a company as one with high or low RoE, we compare RoE of
that company with the sectorial average for that year. To perform our
hypothesis, we have classified companies into a homogeneous group with at
least two players in industry.
Our analysis of BSE 200 companies (current constituents – where data is
consistently available from FY03 (125 companies )and can be further classified
into homogenous groups (103 companies ) over the last three cycles (FY03-FY08,
FY08-FY13 and FY13-FY19) highlights that while high-RoE companies (where
yearly RoE is higher than average sector RoE in more than 50% of times over
chosen tested phase) trade at rich valuation multiples, they do not materially
outperform the sector peers.
High-RoE companies outperformed peers by a material difference (aggregate
MC CAGR of 17% v/s 14% for low-RoE companies) in one cycle (FY13-19). In the
other two phases, the difference in MC CAGR of high- and low-RoE companies
was marginal. For example, over FY03-08, MC CAGR was 42% for high-RoE
companies and 42% for low-RoE companies. Over FY08-13, low-RoE companies
(MC CAGR of 9%) marginally outpaced high-RoE companies (MC CAGR of 8%).
Sectorally, the breadth of outperformance by high-RoE companies v/s low-RoE
companies in all three time cycles is also marginal. We believe that since the
markets are efficient, high RoEs (read as current competitive advantages) are
clearly understood and well factored in the price.
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 34: High-RoE companies marginally outperformed low-RoE companies
over FY03-08
Industry
Auto Ancillaries - Batteries
Auto Ancillaries - Tyres
Automobiles - 2W
Automobiles - CV
Banks
Cements
Chemicals
Consumer electronics
Diamond / Jewellery
Engineering
Finance
FMCG
IT Software
Metals
Oil & Gas
Paints
Personal Products
Pharmaceutical
Refineries
Grand Total
High RoE
MC CAGR % Cos.
83
1
45
2
30
1
37
1
49
9
48
2
21
3
103
1
86
1
86
2
56
2
15
5
25
1
98
6
33
1
40
1
23
1
46
7
24
1
42
48
Low ROE
MC CAGR % Cos.
82
1
36
1
7
2
32
1
58
5
68
2
73
4
25
1
108
1
79
1
21
5
37
5
19
4
45
3
41
1
50
2
26
1
28
11
45
4
42
55
Sector
MC CAGR % Cos.
83
2
41
3
26
3
36
2
52
14
50
4
46
7
78
2
90
2
80
3
45
7
24
10
22
5
80
9
34
2
42
3
25
2
38
18
41
5
42
103
Source: Capitaline, MOFSL
High RoE companies do not
generate material
outperformance.
Exhibit 35: Low-RoE companies marginally outperformed high-RoE companies
over FY08-13
Industry
Auto Ancillaries - Batteries
Auto Ancillaries - Tyres
Automobiles - 2W
Automobiles - CV
Banks
Cements
Chemicals
Consumer electronics
Diamond / Jewellery
Engineering
Finance
FMCG
IT Software
Metals
Oil & Gas
Paints
Personal Products
Pharmaceutical
Refineries
Grand Total
High RoE
MC CAGR %
Cos.
34
1
23
2
17
1
27
1
16
10
21
2
34
3
38
1
37
1
-16
1
15
3
21
5
15
1
-6
4
5
1
33
1
29
1
25
8
-5
2
8
49
Low ROE
MC CAGR % Cos.
15
1
16
1
41
2
4
1
8
4
7
2
6
4
-16
1
16
1
-1
2
16
4
26
5
16
4
-13
5
2
1
34
2
18
1
14
10
7
3
9
54
Sector
MC CAGR %
19
20
21
25
14
11
16
-4
33
-12
15
23
16
-9
5
33
24
20
-3
8
Cos.
2
3
3
2
14
4
7
2
2
3
7
10
5
9
2
3
2
18
5
103
Source: Capitaline, MOFSL
February 2020
22
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 36: High-RoE companies outperformed materially over FY13-19
Industry
Auto Ancillaries - Batteries
Auto Ancillaries - Tyres
Automobiles - 2W
Automobiles - CV
Banks
Cements
Chemicals
Consumer electronics
Diamond / Jewellery
Engineering
Finance
FMCG
IT Software
Metals
Oil & Gas
Paints
Personal Products
Pharmaceutical
Refineries
Grand Total
High RoE
MC CAGR % Cos.
17
1
34
2
9
1
-7
1
24
7
26
2
18
2
38
1
28
1
12
2
25
2
23
5
13
3
13
5
-5
1
20
1
27
1
15
11
23
2
17
51
Low ROE
Sector
MC CAGR % Cos. MC CAGR % Cos.
9
1
12
2
20
1
30
3
45
2
22
3
29
1
-2
2
11
7
20
14
8
2
15
4
22
5
20
7
42
1
40
2
33
1
29
2
-8
1
2
3
18
5
24
7
9
5
15
10
7
2
11
5
5
4
10
9
12
1
-2
2
27
2
22
3
22
1
25
2
11
7
13
18
21
3
21
5
14
52
16
103
Source: Capitaline, MOFSL
Change in RoE leads to higher wealth creation
Companies with improving
RoE trajectory get rerated
and outperform peers.
Interestingly, our analysis of BSE200 companies (current constituents – where
data is consistently available from FY03) over the last three cycles (FY03-FY08,
FY08-FY13 and FY13-FY19) highlights that the change in the RoE of companies
has a material impact on market cap creation.
Across all three phases, companies delivering RoE improvement (at end v/s start
of the respective period) have significantly outperformed those witnessing a
decline in RoE. Companies with improving RoE has delivered aggregate market
cap CAGR of (i) 52% (v/s 35% for others) over FY03-08, (ii) 21% over FY08-13 (v/s
4% for others) and (iii) 25% over FY13-19 (v/s 18% for others).
Also, across phases, the number of sectors in which improving RoE companies
delivered much better MC based returns (v/s falling RoE companies) was high.
FY03-08
Improving Declining
50
30
86
60
43
44
78
42
50
NA
46
44
19
38
49
34
33
NA
80
NA
52
50
56
12
54
29
90
NA
20
24
97
NA
63
NA
52
35
FY08-13
Improving Declining
25
19
17
18
19
8
21
-6
NA
11
22
13
23
28
28
20
14
NA
NA
-9
40
2
16
15
NA
0
37
16
27
14
NA
-7
NA
-2
21
4
FY13-19
Improving Declining
44
11
NA
29
NA
13
22
16
7
22
15
30
23
19
40
11
NA
16
16
9
41
20
83
21
21
15
NA
36
10
14
NA
4
-3
NA
25
18
Source: MOFSL
Exhibit 37: Companies with RoE improvement outperform across phases (M-cap CAGR %)
Sector
Automobiles
Banks - Private Sector
Banks - Public Sector
Capital Goods
Cement
Chemicals
Consumer
Healthcare
Media
Metals
Miscellaneous
NBFC
Oil & Gas
Retail
Technology
Telecom
Utilities
Grand Total
February 2020
23
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CONCLUSION 4
Capital structure-led RoE improvement uplifts valuations
Efficient capital allocation leads to wealth creation
Cash rich companies
can improve their RoE
by increasing earnings
payout, which, in turn,
would uplift valuation
multiple.
RoEs of companies can be improved either by accelerating earnings momentum
(numerator) or employing a superior capital allocation strategy (denominator).
Our hypothesis is that cash-rich companies can optimize their capital allocation by
increasing payouts (of surplus cash) to shareholders and in turn achieve better
RoEs/valuation multiples. This is confirmed by our case studies on TCS, ITC and
Hindustan Zinc – these companies garnered better valuation multiples on improved
RoE led by step up in shareholder payouts (dividends/buybacks).
4
Capital allocation key to generate superior return ratios
RoE of companies could be
improved by accelerating
earnings momentum or by
employing superior capital
allocation strategy.
Capital allocation is a dynamic process under which management has to make
the right use of the one of the scarce resources (capital). It could either deploy
funds generated from operations to expand existing/new business (M&A/capex/
working capital/R&D) to generate superior return on incremental capital
employed or repay the existing debt or return the excess cash back to the
shareholders (as dividend/share buyback).
As generally understood, a company that delivers superior return ratios (other
things being constant) than peers usually gets premium valuations. While RoIC is
used to measure operating efficiency of a business, RoE also factors in financial
efficiency. Thus, a company can generate better RoE (with same RoIC) by
employing a superior capital allocation strategy.
In the previous section, we concluded that the change in RoE helps in market
cap creation for companies. RoEs of companies can be improved either by
accelerating earnings momentum (numerator) or employing a superior capital
allocation strategy (denominator). Our hypothesis is that cash-rich companies
can optimize their capital allocation by increasing payouts to shareholders and
in turn achieve better RoEs/valuation multiples.
Payout strategy change drives rerating: Three case studies
Increase in dividend payout
ratio leads to better
valuation multiple, leading
to superior market cap
creation.
To re-test our hypothesis, we studied three cases to check whether companies
that have returned back surplus capital to shareholders (either in form of
dividends or buybacks) have been rewarded by the market in the form of higher
valuation multiples, leading to superior market cap creation.
February 2020
24
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CASE STUDY 1: TCS
COMPANY BACKGROUND
Tata Consultancy Services Limited
(TCS) is an IT services, consulting
and business solutions
organization and a subsidiary of
Tata Group. It was founded in
1968 by a division of Tata Sons
Limited and at present has
operations across 50 countries. It
got listed in 2004 and became the
first Indian IT company to reach
USD100b market capitalization (in
April 2018). With revenues of
over USD20.9b in FY19, TCS is
ranked among the top 10 global
IT service providers.
HYPOTHESIS PERIOD
Test Period I: FY13-17
Test Period II: FY17-19
STOCK PERFORMANCE
During FY13-17, TCS’ stock clocked
a market cap CAGR of 11.7% on the
back of healthy earnings (CAGR of
17.2%). However, during the
period, RoE declined by 7.4pp (to
33.4% in FY17) and P/E shrank by
18% from 22.1x in FY13 to 18.2x in
FY17. During FY17-19, the change in
payout policy resulted in higher
cumulative payout, which stood at
74% v/s 42% in FY13-17. RoE
expanded by 2.7pp to 36.1% in
FY19. It evoked a positive reaction
in market with the stock clocking a
market cap CAGR of 25.2%, despite
slower earnings growth (CAGR of
9.4%). Thus, P/E expanded by 31%
from 18.2x in FY17 to 23.9x in FY19.
HYPOTHESIS
Better capital allocation by way
of increasing payout from
excess cash could improve RoE
and drive P/E expansion.
TESTING PERIOD HIGHLIGHTS
Particulars
Market CAP (INR b)
CAGR (%)
Earnings (INR b)
CAGR (%)
Net cash (INR b)
Net cash as % of NW
Payout* (INR b)
Cum. Payout ratio
Average RoE (%)
Change in RoE
PE (x)
Change in PE
*including buybacks
FY13
3,076
139
75
19%
43
40.8
22.1
FY17
4,790
263
455
53%
93
33.4
(7.4)
18.2
(3.9)
23.9
5.6
FY13-17
11.7
1035
17.2
FY19
7,506
315
419
47%
273
36.1
2.7
FY17-19
25.2
836
9.4
439
42%
621
74%
MC (INR b)
Payout ratio: 42%
40.8
22.1
3,076
FY13
39.8
43.6
21.8
4,169
FY14
25.1
4,989
FY15
PE (X)
RoE (%)
36.1
23.9
7,506
FY19
39.9
20.4
4,958
FY16
33.4
18.2
4,790
FY17
30.1
21.1
5,454
FY18
MC CAGR (%)
Earnings CAGR (%)
MC CAGR (%)
Earnings CAGR (%)
11.7
Over FY13-17
17.2
25.2
9.4
Over FY17-19
25
February 2020
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CASE STUDY 2: ITC
COMPANY BACKGROUND
ITC is an Indian multinational
conglomerate established in 1910
with headquarters in Kolkata,
West Bengal. It employs more
than 30k people at more than 60
locations across India and is part
of Forbes 2000 list. Along with
~80% cigarettes market share, the
company has diversified its
presence in FMCG, Hotels,
Packing, Paperboard & Speciality
Paper and Agri-Business.
HYPOTHESIS PERIOD
Test period I: FY06-09
Test period II: FY09-14
STOCK PERFORMANCE
Over FY06-09, ITC’s stock clocked a
market cap CAGR of (1.6%) on the
back of earnings CAGR of 13.1%.
However, during the period, RoE
declined by 1.5pp (to 25.3% in
FY09) and P/E shrank by 34% from
31.9x in FY06 to 21.0x in FY09.
Over FY09-14, the change in
payout policy resulted in a higher
cumulative payout, which stood at
60% v/s 42% in FY06-09. RoE
expanded by 10pp to 35.3% in
FY14. It evoked a positive reaction
in the market with the stock
clocking return CAGR of 32.1%,
which was also supported by
earnings CAGR of 21.7%. This has
resulted into P/E expansion by
50% from 21.0x in FY09 to 31.6x in
FY14.
FY06-09
(1.6)
115
13.1
FY14
2,807
89
96
36
48
35.3
(1.5)
10.0
31.6
(10.9)
10.6
FY09-14
32.1
353
21.7
HYPOTHESIS
Better capital allocation by way
of increasing payout from
excess cash could improve RoE
and drive P/E expansion.
TESTING PERIOD HIGHLIGHTS
Particulars
Market CAP (INR b)
CAGR (%)
Earnings (INR b)
CAGR (%)
Net cash (INR b
Net cash as % of NW
Payout (INR b)
Cum. Payout ratio
RoE (%)
Change in RoE
PE (x)
Change in PE
FY06
732
23
34
38
10
26.8
31.9
FY09
698
33
28
20
14
25.3
21.0
49
42%
211
60%
MC (INR b)
Payout ratio: 42%
31.9
26.76
27.74
20.5
732
FY06
566
FY07
27.54
24.6
778
FY08
25.27
21.0
698
FY09
PE (X)
29.26
24.1
1005
FY10
RoE (%)
32.43
28.0
1404
FY11
34.82
28.3
1774
FY12
35.70
32.1
35.29
31.6
2807
FY14
2442
FY13
MC CAGR (%)
Earnings CAGR (%)
13.1
MC CAGR (%)
Earnings CAGR (%)
32.1
-1.6
Over FY06-09
February 2020
Over FY09-14
21.7
26
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CASE STUDY 3: HINDUSTAN ZINC
COMPANY BACKGROUND
Hindustan Zinc Limited (HZL) is an
integrated mining and resource
producer of zinc, lead, silver and
cadmium. Incorporated in 1966
as a PSU, the company went into
privatization in 2002 when
Sterlite Opportunities and
Ventures Limited (now part of
Vedanta Limited) bought a 26%
stake, including management
control. Over time, Vedanta
bought a majority stake in the
company (64.9%), making HZL its
subsidiary. HZL is now India’s
largest and the world's second
largest zinc-lead miner with
annual ore production capacity of
17.7MMT.
HYPOTHESIS PERIOD
Period I: FY12-15
Period II: FY15-19
STOCK PERFORMANCE
Over FY12-15, HZL's stock clocked
a market cap CAGR of 7% on the
back of EBITDA CAGR of 14%.
However, RoE declined by 2.2pp
(to 20.2% in FY15) and EV/EBITDA
multiple declined by 5% from 6.7x
in FY12 to 6.3x in FY15. Over FY15-
19, a change in the payout policy
resulted in a higher cumulative
payout (91% v/s 21% over FY12-
15). This has led to RoE expansion
by 2.7pp from 20.2% in FY15 to
22.9% in FY19. It evoked positive
reaction in the market, with the
stock clocking a market cap CAGR
of 14.3%, despite earnings de-
growth (CAGR of -0.7%). As a
result, EV/EBITDA multiple
expanded by 51% from 6.3x in
FY15 to 9.6x in FY19.
HYPOTHESIS
Better capital allocation by way
of increasing payout could
improve RoE and support
multiple expansion.
TESTING PERIOD HIGHLIGHTS
Particulars
Market CAP (INR b)
CAGR (%)
Earnings (INR b)
CAGR (%)
Net Cash (INR b)
Net cash as % of NW
Payout (INR b)
Cum. Payout ratio
RoE (%)
Change in RoE
EV/EBITDA (x)
Change in EV/EBITDA
MC (INR b)
RoE (%)
FY12
558.8
55.3
179.47
67
18.9
22.4
6.7
FY15
683.9
81.8
307.9
71
23.7
20.2
(2.2)
6.3
(0.4)
EV/ EBITDA (x)
27.8
22.4
6.7
559
FY12
23.3
5.2
512
FY13
19.8
5.8
542
FY14
20.2
6.3
684
FY15
20.3
8.3
775
FY16
24.4
10.0
1,220
FY17
8.8
1,272
FY18
9.6
3.3
FY12-15
7.0
275.1
14.0
FY19
1,167.9
79.6
169.7
51
106.2
22.9
2.7
FY15-19
14.3
419.0
(0.7)
56.6
21%
378.6
91%
22.9
9.6
1,168
FY19
MC CAGR (%)
Earnings CAGR (%)
MC CAGR (%)
14.3
Earnings CAGR (%)
7.0
Over FY12-15
February 2020
14.0
Over FY15-19
-0.7
27
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CONCLUSION 5
Mid-caps: Lower RoE but outperformance to large-caps
Potential RoE improvement and higher earnings growth the enablers
5
Mid-cap companies
have outperformed
Large-cap despite lower
RoE in three tested
cycles over FY03-19.
This is due to High PAT
growth and RoE
variability
The underperformance of midcaps vis-à-vis large caps since FY17 is well known.
However, an analysis of the last 10-year performance reveals that the performance of
both the Nifty and the Nifty Midcap 100 has been cyclical, with the latter
outperforming from a longer-term perspective.
Over the three tested cycles (FY03-08, FY08-13 and FY13-19), mid-cap companies (excl.
BFSI) have outperformed large-caps in market cap creation (percentage wise) by a
significant margin. This is despite mid-caps have lower RoEs than large-caps in all the
three tested cycles. This, in our view, is primarily on account of higher earnings growth
and thus higher variability (improvement) in RoEs for mid-caps.
Mid-cap underperformance cyclical – more of last two years’ phenomenon
Mid-caps’ underperformance to large caps since FY17 is well known. However,
looking at the last 10 years’ performance of the indices (Nifty v/s Nifty Midcap
100), we have observed a clear evidence of cyclicality.
Both the indices had performed quite linearly from Dec’09 to Dec’14 with mid-
caps maintaining outperforming. However, from Dec’14 to Dec’17, the midcap-
100 index had significantly outperformed the Nifty-50. The trend though has
changed in the recent times in favor of Nifty-50.
Midcap has outperformed
Large-cap over the long
term. However, they have
underperformed large cap
since Dec’17
Exhibit 38: Nifty Midcap-100 corrected 19.1% from peak in Dec’17
700
600
500
400
300
200
100
Nifty Rebased
Nifty Midcap 100 Rebased
Nifty Midcap corrected
19.1% from its peak
502
403
Source: Capitaline, MOFSL
A comparison of the performance at the index level may not present the correct
picture due to the inclusion/exclusion of certain stocks from the respective
benchmarks, their change in weightage in the index and the crossover of well-
performing stocks from mid-caps to large-caps (and vice versa).
To understand RoE of stocks by market cap and its impact on market cap
creation, we have used the SEBI classification of large-caps (top 100 stocks by
market cap) and mid-cap companies (those with market cap rank from 101-250).
Our analysis has been detailed below.
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Midcap outperformed across three tested time cycles
Mid-caps outperformance
to large-caps is primarily
driven by higher variability
in RoE and earnings growth.
Over the last 16 years, mid-caps have outperformed large-caps in market cap
creation (percentage-wise) across three different phases. This is despite
generally higher RoE of large-caps than that of mid-caps.
To understand the reason behind this, we have looked at RoE of large-caps
(defined as top BSE100 companies by market cap as at the start of respective
base year) and mid-caps (defined as BSE 101 - BSE 250 by market cap of the
respective base year) over three phases (FY03-08, FY08-13 and FY13-19).
We have chosen three different phases to primarily factor in the shift of
companies from mid to large-cap (or vice versa), or exclusion from the
meaningful universe.
Mid-caps outperformed large-caps in market cap creation (percentage wise) in
all the three tested periods. This, in our view, was primarily due to: (i) much
higher improvement (variability) in RoE of mid-caps and (b) high earnings
growth.
Earnings growth of mid-cap companies was almost 2x that of large-cap
companies over two phases (FY03-08 and FY08-13). However, over FY13-19,
mid-cap PAT declined at a compounded annual rate of 7.0%. This was
attributable mainly to the loss-making PSBs which distorted the picture. PAT
CAGR of mid-caps (ex BFSI) over FY13-19 stood at 14.1% v/s 4.7% for large caps
(ex BFSI).
Exhibit 40: …so did ex-BFSI in all three phases
Mid Cap RoE- Ex BFSI
24.1%
Large Cap RoE - Ex BFSI
Exhibit 39: Large-cap average RoE outperformed mid-caps…
Mid Cap RoE
21.7%
15.8%
16.2%
14.4%
7.1%
Large Cap RoE
11.6%
16.4%
16.7%
14.5%
13.1%
10.9%
FY 03-08
FY 08-13
FY 13-19
FY 03-08
FY 08-13
FY 13-19
Source: Capitaline, Bloomberg and MOFSL
Source: Capitaline, Bloomberg and MOFSL
Exhibit 41: Large-caps RoE…
Large Cap RoE
30%
23%
15%
8%
0%
Mid Cap RoE
Exhibit 42: …outperform
Large Cap RoE
30%
23%
15%
8%
0%
Mid Cap RoE
Exhibit 43: …mid-caps RoE (ex. BFSI)
Large Cap RoE
20%
15%
10%
5%
0%
Mid Cap RoE
Source: Capitaline, Bloomberg and MOFSL
Source: Capitaline, Bloomberg and MOFSL
Source: Capitaline, Bloomberg and MOFSL
February 2020
29
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 44: Mid-cap MC CAGR outpaced large-cap MC...
Mid Cap MC
66.5%
45.1%
20.7%
12.8%
3.4%
FY 03-08
FY 08-13
FY 13-19
Large Cap MC
Exhibit 45: …so did PAT CAGR except for FY13-19 due to loss
making PSBs
Mid Cap PAT
58.2%
26.5%
8.2% 5.9%
FY 03-08
FY 08-13
2.3%
-7.0%
FY 13-19
Large Cap PAT
14.1%
Source: Capitaline, Bloomberg and MOFSL
Source: Capitaline, Bloomberg and MOFSL
Exhibit 46: Ex-BFSI, mid-cap MC CAGR outpaces large caps…
Mid Cap MC - Ex BFSI
65.6%
44.2%
Large Cap MC - Ex BFSI
Exhibit 47: …in line with PAT CAGR (ex BFSI)
Mid Cap PAT- Ex BFSI
56.4%
Large Cap PAT- Ex BFSI
28.8%
13.6%
1.9%
FY 03-08
FY 08-13
20.1%
11.1%
14.1%
4.4% 2.3%
FY 03-08
FY 08-13
4.7%
FY 13-19
FY 13-19
# CAGR over the period
Source: Capitaline, Bloomberg and MOFSL
# CAGR over the period
Source: Capitaline, Bloomberg and MOFSL
Exhibit 48: Summary table of PAT and market cap over the period (INR t)
Particulars
FY03
Absolute PAT
Large Cap
Mid Cap
Absolute PAT EX BFSI
Large Cap
Mid cap
Absolute MC
Large Cap
Mid Cap
Absolute MC EX BFSI
Large Cap
Mid cap
0.6
0.0
0.4
0.0
4.3
0.2
3.7
0.2
Period 03-08*
FY08
1.8
0.2
1.5
0.2
27.9
3.0
23.1
2.7
FY08
2.1
0.3
1.8
0.2
36.2
4.0
30.9
3.3
Period 08-13*
FY13
2.9
0.5
2.0
0.3
42.7
7.7
33.9
6.2
FY13
3.2
0.5
2.4
0.2
47.8
7.3
38.5
5.9
Period 13-19*
FY19
3.7
0.3
3.1
0.5
98.5
22.7
72.4
17.6
*Companies are categorized between Large Cap and Mid cap based on ‘base year’ market capitalization for each period separately.
For eg. Period FY03-08 has base period as FY03.This data universe of companies under Mid-cap/Large-cap changed across the periods.
Source: Capitaline, Bloomberg and MOFSL
February 2020
30
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
CONCLUSION 6
Improving RoE and PAT growth – a lethal combination
Optimal mix for market cap creation
Companies with 'improving RoE' and 'earnings growth' are the best for market cap
creation. Our analysis of BSE500 companies over two phases (from FY08-13 and FY13-
19)
revealed that companies with both improving RoE and earnings are ideal for
generating best returns, while those with declining RoE/earnings growth have
delivered the weakest market cap returns.
Companies with
‘improving RoE’ and
‘earnings growth’ are
best for market cap
creation.
A few companies appear attractive based on the framework of improving RoEs and
increase in PAT growth estimates for FY20-22: Large-caps: (a) Axis Bank , Bharti Airtel,
Hindustan Unilever, Infosys and Ultratech Cement. (b) Mid-caps: Federal Bank, JSW
Energy, Tata Global, Trent and Voltas.
6
What’s the secret to generating best investor returns?
As concluded earlier, since the markets are efficient, in most cases, the quality
of capital efficiency is priced in. Given this, it is the deepening or narrowing of
the moat (i.e. delta or improvement in RoE) that influences stock prices more
than the absolute levels. Similarly, companies in the high-growth phase will
continue to be materially re-rated till the time growth in earnings continues to
improve. As earnings growth saturates, valuation multiples also peak out.
If we put all this in a 2*2 matrix by taking an improvement and a decline in the
RoE on the y-axis, and an increase and decline in the earnings growth on the x-
axis, we conclude that in order to generate superior market cap returns, the
lethal combination of RoE and PAT growth is a must.
Exhibit 49: RoE and PAT framework
Improving RoE and PAT
growth is the best
combination for market cap
creation.
IMPROVING
RoE Improving and
PAT Growth
Decrease
RoE Declining and
PAT Growth
Decrease
DECREASING
RoE Improving and
PAT Growth Increase
ROE
DECLINING
RoE Declining and
PAT Growth Increase
INCREASING
PAT GROWTH
Source: MOFSL
In order to back test our hypothesis, we analyzed BSE500 companies where
consistent data was available for the last 16 years (FY03-19). We divided the
entire period into three phases (Phase I: FY03-08, Phase II: FY08-13 and Phase
III: FY13-19) and determined average RoE and earnings CAGR of stocks in each
of the phases. We further removed the companies reporting negative
profitability either at the start or the end of the phase. Based on this, we
shortlisted stocks that qualify for being classified in each quadrant using data of
the prior phase as the base.
February 2020
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 Motilal Oswal Financial Services
Thematic | India Inc. RoE
According to our analysis, for both the tested periods (FY08-13 and FY13-19),
companies in the quadrant with improving RoE/growth delivered the best
market cap CAGR, while those in the quadrant with declining RoE/earnings
CAGR delivered weakest market cap growth.
We note that in the tested period of FY13-19 the companies with improving RoE
and declining PAT growth delivered a slight better market cap return
(CAGR24.9%) than the companies with improving RoE and PAT growth (CAGR
22.9%) this is primarily on account of few BFSI companies (HDFC Bank, Bajaj
Finance, IndusInd Bank and Cholamandalam finance) where the cumulative PAT
growth remained high (FY13-19: 24.6%) but moderated on a high base (FY08-13:
38.4%).
Exhibit 51: RoE and PAT growth framework based on phase II
& III – market cap CAGR (%)
Exhibit 50: RoE and PAT growth framework based on phase I
& II – market cap CAGR (%)
IMPROVING
17.2
9.2
DECREASING
21.1
ROE
IMPROVING
24.9
11.4
DECREASING
22.9
17.3
INCREASING
ROE
WEAKENING
17.4
INCREASING
WEAKENING
Relative PAT Growth
Source: Capitaline, Bloomberg & MOFSL
Relative PAT Growth
Source: Capitaline, Bloomberg & MOFSL
Exhibit 52: Ex BFSI - RoE and PAT growth framework based on Exhibit 53: Ex BFSI - RoE and PAT growth framework based on
Phase I & II – market cap CAGR (%)
phase II & III – market cap CAGR (%)
IMPROVING
16.0
8.0
DECREASING
21.1
ROE
IMPROVING
17.3
10.5
DECREASING
22.8
16.0
INCREASING
ROE
WEAKENING
18.4
INCREASING
WEAKENING
Relative PAT Growth
Source: Capitaline, Bloomberg & MOFSL
Relative PAT Growth
Source: Capitaline, Bloomberg & MOFSL
Actionable – companies with improving RoEs and increasing PAT growth
Improvements in RoEs and
increase in earnings growth
are important factors for
market cap creation.
Our study concludes that an improvement in RoE and earnings growth is key for
wealth creation.
To narrow out and derive a meaningful list of the companies under our MOFSL
coverage, we have taken 20% improvement in both RoE (estimated for FY22
over the median of FY16-20) and relative PAT growth (CAGR over FY20-22E v/s
CAGR over FY15-20) as the threshold level.
Our top picks based on the above hypothesis are:
Large-caps:
Axis Bank, Bharti Airtel, Hindustan Unilever, Infosys and
Ultratech Cement.
Mid-caps:
Federal Bank, JSW Energy, Tata Global, Trent and Voltas.
February 2020
32
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Some Interesting thoughts on RoE
February 2020
33
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Point 1
RoE ex-goodwill: Not a good comparable yardstick
We believe RoEs excluding
goodwill does not reveal
true picture and leads to
incorrect comparison of
companies
For a number of acquisitive companies, goodwill comprises a significant
proportion of their net worth. Some investors prefer to look at a company’s RoE
excluding the value of goodwill, primarily because they consider goodwill (its
write off) to be non-cash in nature and/or part of sunk cost.
In the Indian context, goodwill represents the premium that has been paid
(either over the book value – as was the case prior to Ind-AS adoption, or the
real premium paid for acquiring the ready asset/brand post Ind-AS). Thus, we
believe that goodwill is cash expensed in advance to acquire the asset.
We believe that looking at a company’s RoE excluding goodwill does not reveal
the true picture and leads to an incorrect comparison of companies that have
invested to grow their business captively with companies that have acquired a
ready business to achieve growth.
It must be noted that companies growing their business captively have made
significant investments (in time and resources) to create an asset/brand. Also,
excluding the value of goodwill for calculating RoE, in our view, would mean that
in the case of acquiring companies, the upside in profits due to their acquisitions
has been factored in after ignoring the cost incurred to acquire the asset.
Exhibit 54: Large caps with goodwill more than 5% of net worth (INR b)
Company
UPL
Godrej Consumer
Cadila Healthcare
Bharti Airtel
Ambuja Cement
Hindalco Inds
Grasim Inds
HCL Technologies
Piramal Enterp
Motherson Sumi
Wipro
Cipla
Lupin
Marico
Sun Pharma.Inds
Tech Mahindra
Adani Ports
Oracle Fin.Serv
Berger Paints
L & T Infotech
Havells India
Torrent Pharma.
ONGC
Aurobindo Pharma
Dabur India
Tata Steel
Infosys
Zee Entertainmen
M&M
Goodwill
150.5
49.2
52.9
332.6
78.8
185.7
179.7
90.6
59.4
22.1
113.2
28.7
23.8
5.0
59.6
28.2
32.7
6.1
2.7
4.9
3.2
3.3
140.9
8.3
3.4
40.0
35.4
5.3
20.7
% of NW
103%
68%
51%
47%
35%
32%
32%
22%
22%
20%
20%
19%
17%
17%
14%
14%
13%
12%
11%
10%
8%
7%
6%
6%
6%
6%
5%
5%
5%
Source: Capitaline, Bloomberg & MOFSL
February 2020
34
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Point 2
Can a change in accounting treatment materially impact
return ratios? YES!
Change in accounting ratios
can impact return ratios
significantly
RoE of high-dividend-paying defensives sectors such as Technology and
Consumer declined by 300bp and 610bp, respectively, over FY15-19, despite a
marginal contraction (Technology) and expansion (Consumer) in their NP
margins.
We believe that the decline in asset turns can be primarily attributed to a
change in the dividend accounting policy post the implementation of Ind-AS,
which requires companies to make provisions for dividends in the accounting
year in which it was approved during the AGM. This is unlike the previous
accounting standard that mandated companies to provide for dividends in the
same year for which the dividends pertained. This led to a temporary
postponement of dividend provisions in FY16, resulting in a sharp increase in net
assets and net worth compared to the previous year.
.
Case Study: HUL
we have adjusted dividend for FY16-19 according to the erstwhile accounting standard by adjusting
dividend in net worth and increasing provision in the year of dividend declaration (and not in the year of the dividend’s AGM
approval as required by Ind-AS). This resulted in higher asset turns and financial leverages, and consequently, an increase in
RoE. In FY19, adjusted RoE stood at a high of 135.3% versus reported RoE of 77.0%.
Exhibit 55: Adj. RoE climbs higher as…
Reported RoE
101.4%
63.2%
108.3%
Adjusted RoE
135.3%
125.7%
77.0%
4.1
Exhibit 56: …asset turns increase and…
Asset Turns
5.9
4.0
5.9
4.0
Asset Turns - Adj
6.1
3.9
5.9
Exhibit 57: …so does financial leverage
Financial Leverage
Financial Leverage - Adj
1.3
1.2
1.4
1.2
1.4
1.3
1.5
66.4%
71.6%
1.2
2016
2017
2018
2019
2016
2017
2018
2019
2016
2017
2018
2019
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Exhibit 58: Adj. RoE for consumer sectors higher…
Reported RoE
29.6%
29.6%
26.4%
26.8%
26.0%
26.1%
Adjusted RoE
Exhibit 59: …same is the case for Technology
Reported RoE
28.0%
28.0%
25.8%
24.2%
24.5%
25.2%
26.5%
Adjusted RoE
23.7%
2015
2016
24.0%
2017
23.4%
2018
23.5%
2019
2015
2016
23.2%
2017
23.8%
25.0%
2018
2019
Source: Capitaline, MOFSL
*Reported and adjusted RoE is calculated on closing new worth
Source: Capitaline, MOFSL
February 2020
35
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
ANNEXURE 1
Divergent trend of sectoral RoE: 2015-2019
RoE of BSE500 (ex PSB’s,
Auto and Telecom)
increased from 12.5% in
FY15 to 14.0% in FY19.
Index RoE has been on a downtrend over the past few years – from 22.7% in
FY08 to 9.5% in FY19. However, we believe one should look at sectorial RoE to
assess the macro picture.
From FY15, some sectors showed signs of a recovery with RoE of
Metals increasing from 4.1% in FY15 to 16.2% in FY19 – contributing 0.9% of
BSE500 index RoE improvement over FY15-19, primarily driven by rising
global metal prices.
Oil & Gas up from 10.5% to 13.9% – contributing 0.6% of index RoE
improvement due to price deregulation, adding significantly to incremental
profit pool of OMCs.
Capital goods increasing to 16.4% from 4.5% in FY15 with 0.4% contribution
to index RoE improvement.
However, of the 270bp decline in index RoE over FY15-19, ~250bp was
contributed by PSBs, mainly due to the asset quality review in FY16. This process
of cleaning the book of banks has increased asset provisioning and ultimately
took a toll on profits of various PSBs.
Automobile also contributed 80bp to the decline in index RoE, with sector RoE
down from 20.2% in FY15 to 3.6% in FY19. This was mainly due to the weak
operating performance of TAMO (excl. TAMO, auto RoE stood at 17.4%).
Disruption by Reliance-Jio affected the margins of telecom players across the
board. This, along with higher capital expenditures and spectrum charges,
dragged RoE of telecom companies from 8.0% to -18.1% in FY19. As a result,
index RoE declined by 0.7%.
Due to significant changes in these sectors, index RoE declined over the period.
Excluding PSBs, Auto and Telecom, index RoE was up by nearly 150bp to 14.0%
in FY19 from a decade low of 12.5% in FY15, led primarily by an improvement in
the profitability margin. NP margin improved to 8.0% in FY19 from 6.9% in FY15.
Asset turns declined materially post FY15 but stabilized at 0.51x.
Further, companies in the high-dividend-paying sectors such as Consumer and
Technology were adversely impacted by the implementation of Ind-AS. The
structural reform of demonetization in FY17 and the rollout of GST in FY18 led to
some temporary hiccups in corporate earnings growth and RoE.
Exhibit 60: RoE of BSE500 companies (ex PSBs, Auto and Telecom) on uptrend post FY15
(%)
23.5
22.7
16.2
16.2
18.1
18.1
BSE 500 EX PSB's, Auto and Telecom
18.2
18.0
15.7
15.8
15.0
14.7
14.8
14.0
BSE 500
12.5
12.2
12.8
10.9
14.1
14.6
14.0
11.8
10.2
9.5
Source: Capitaline, MOFSL
February 2020
36
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Exhibit 61: Sectors showing RoE improvement post FY15
60.0%
45.0%
30.0%
15.0%
0.0%
Metals
Capital Goods
Chemicals
Oil & Gas
Diversified
Exhibit 62: RoE dipped for PSBs, Auto and Telecom
Telecom
40.0%
20.0%
0.0%
-20.0%
-40.0%
Banks - PSU
Automobile
Source: Capitaline, MOFSL
Source: Capitaline, MOFSL
Exhibit 63: Margins – key driver of RoE improvement (%)…
NP Margin
Exhibit 64: …asset turn (x) stabilizes (BSE500 Ex PSB, auto,
Tele)
Asset Turnover
Source: MOFSL
Source: MOFSL
Exhibit 65: Leverage continues to rise (x)
Financial Leverage
Exhibit 66: Profitability improvement driven by NP margin
FY15 - FY19
15%
10%
BSE 500
BSE 500 EX PSB's, Auto and Telecom
-5%
-17%
NP Margin
Source: Capitaline, MOFSL
-12%
Asset Turnover
0%
Financial Leverage
Source: Capitaline, MOFSL
Global Cyclicals witness significant RoE improvement and drive index RoE
RoE of oil and gas increased
by 340bps to 13.9% and
metals by 1210bps to 16.2%
over FY15-19
Over FY15-19, Global Cyclicals – Oil & Gas and Metals – witnessed a sharp
improvement in RoE, led by a rise in their profitability as the cycle turned
favorable. Also, as these sectors are heavyweights, they contributed significantly
to overall index RoE improvement.
RoE of Oil & Gas increased by 340bp to 13.9% and of Metals by 1,210bp to
16.2% off a low base. Accordingly, in FY19, RoE contribution of Oil & Gas and
Metals increased to 2.3% (FY15: 1.7%) and 1.3% (FY15: 0.4%), respectively.
February 2020
37
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Also, Capital Goods RoE improved to 16.4% in FY19 from 4.5% in FY15, and its
contribution to index RoE increased to 0.6% from merely 0.2%. Other sectors
witnessing an RoE improvement were Chemical, Real estate and Diversified.
RoEs of Defensives/Domestic Cyclicals decline
RoE of telecom and
healthcare companies
declined by 26.0% and 9.3%
respectively over FY15-19
Over FY15-19, most companies in Defensives and Domestic Cyclicals witnessed a
decline in RoE, primarily due to a contraction in the NP margin.
Telecom and Healthcare RoE declined by 26% and 9.3%, respectively, primarily
due to rising competitiveness in these sectors.
This was followed by Consumer sector, where RoE declined 6.7% despite better
profitability. A similar trend was observed in Technology.
Contribution of Domestic Cyclicals and Defensives (which witnessed an RoE
decline) to index RoE decreased to 4.8% in FY19 from 6.3% in FY15.
Exhibit 67: Cyclical sectors contributed for RoE improvement over FY15-19 (%)
Sector
Global Cyclical
Metals
Oil & Gas
Domestic Cyclicals
Automobiles
Capital Goods
Chemicals
Diversified
Infrastructure
Misc
Real Estate
Retail
Utilities
Defensive
Cement
Consumer
Healthcare
Media
Retail
Technology
Telecom
Textiles
BFSI
Banks - Private Sector
Banks - Public Sector
Insurance
NBFC
Grand Total
FY15 ROE
FY15 ROE
Contribution
2.2
0.4
1.7
2.5
1.1
0.2
0.2
0.0
-0.1
0.3
0.1
0.0
0.7
3.8
0.2
0.8
0.7
0.1
0.1
1.6
0.2
0.1
3.8
1.2
1.2
0.2
1.2
12.2
FY19 ROE
FY19 ROE
Contribution
3.6
1.3
2.3
2.0
0.2
0.6
0.2
0.0
-0.1
0.4
0.1
0.0
0.5
2.8
0.2
0.8
0.5
0.1
0.1
1.6
-0.4
0.1
1.1
0.9
-1.4
0.2
1.4
9.5
Change in ROE
over FY15 - FY19
12.1
3.4
-16.6
11.9
1.4
10.8
-2.0
2.7
3.2
-2.2
-1.3
-1.2
-6.7
-9.3
-6.0
-8.6
-3.0
-26.0
-1.3
-7.1
-19.2
-0.2
-2.0
-2.7
Change in
Contribution to
Index RoE
0.9
0.6
-0.8
0.4
0.1
0.0
0.0
0.1
0.0
0.0
-0.2
0.0
0.0
-0.2
0.0
0.0
-0.1
-0.7
0.0
-0.2
-2.5
-0.1
0.1
-2.7
4.1
10.5
20.2
4.5
13.5
7.6
-8.3
8.5
4.4
19.7
9.7
11.0
31.6
20.5
14.6
24.0
29.0
8.0
9.8
16.9
8.3
12.8
16.7
12.2
16.2
13.9
3.6
16.4
14.9
18.4
-10.2
11.2
7.6
17.5
8.4
9.8
24.9
11.3
8.6
15.4
26.0
-18.1
8.5
9.7
-10.9
12.5
14.7
9.5
Source: Capitaline, MOFSL
February 2020
38
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
ANNEXURE 2
Rising era followed by downward era
Rising Era: 2003-08: Contribution of Global Cyclicals lifts index RoE;
improvement across sectors
Global cyclical sectors
contributed 6.9% out of
16.8% of index RoE in FY03
and 8.6% out of 22.7% in
FY08
Over the period of upcycle, the contribution of Global Cyclicals to index RoE was
the highest and increased from 6.9% (of 16.8% index RoE) in FY03 to 8.6% (of
22.7% index RoE) in FY08.
Oil & Gas contributed ~6.3% in FY03 and 4.9% in FY08, despite a decline of
200bp in the sector’s RoE to 24.1% in FY08. On the other hand, the contribution
of Metals sector to the index RoE increased from 0.6% in FY03 to 3.7% in FY08.
Of the increase of 5.9% in the index RoE for the period, the contribution of
Metals was at 3.1% as the sector’s RoE rose from 9.1% in FY03 to 36.1% in FY08.
Domestic Cyclicals’ contribution to RoE increased to 5.1% in FY08 from 3.1% in
FY03, with a meaningful rise in the contribution of Capital Goods (RoE up from
14.1% to 28.2%). Real Estate RoE increased significantly to 48.6% from 7.1%,
leading to an increase in its contribution to 0.8% from negligible in FY03.
Defensives’ contribution rose the highest by 250bp to 4.8% in FY08 from 2.3% in
FY03, led by Technology (RoE up 1,020bp), Telecom (RoE up to 23.7% from -
1.4% in FY03) and Cement (RoE up to 39.2% from 3.2% in FY03).
On a contrary, BFSI’s RoE contribution declined from 4.5% in FY03 to 4.2% in
FY08. RoE of private sector banks and public sector banks declined by 440bp and
350bp to 13.1% and to 17.1%, respectively, over the same period.
FY03 ROE
Contribution
6.9
0.6
6.3
3.1
0.5
0.6
0.1
0.0
0.1
0.3
0.0
NA
1.5
2.3
0.0
1.0
0.5
0.1
0.0
0.6
0.0
0.1
4.5
0.5
3.0
0.1
0.9
16.8
FY08 ROE
Contribution
8.6
3.7
4.9
5.1
0.9
1.1
0.3
0.1
0.1
0.5
0.8
0.0
1.3
4.8
0.6
0.9
0.7
0.0
0.0
1.3
1.0
0.3
4.2
0.7
2.2
0.2
1.1
22.7
Change in ROE over
FY03 - FY08
27.0
-2.0
11.2
14.1
15.9
32.0
-0.1
5.8
41.4
1.4
36.0
9.1
2.2
1.2
25.6
10.2
25.1
13.1
-4.4
-3.5
1.5
4.8
5.9
Change in
Contribution to
Index RoE
1.7
3.1
-1.4
2.0
0.4
0.5
0.2
0.1
0.1
0.2
0.8
0.0
-0.3
2.5
0.5
-0.2
0.2
0.0
0.0
0.8
1.1
0.1
-0.3
0.2
-0.8
0.1
0.2
5.9
Exhibit 68: Most sectors witnessed RoE improvement over FY03-08 (%)
Particulars
Global Cyclical
Metals
Oil & Gas
Domestic Cyclical
Automobiles
Capital Goods
Chemicals
Diversified
Infrastructure
Misc
Real Estate
Retail
Utilities
Defensive
Cement
Consumer
Healthcare
Media
Retail
Technology
Telecom
Textiles
BFSI
Banks - Pvt
Banks – PSU
Insurance
NBFC
Grand Total
FY03 ROE
FY08 ROE
9.1
26.1
14.1
14.1
5.4
13.0
13.8
7.6
7.1
NA
10.2
3.2
28.1
24.5
7.2
12.7
23.8
-1.4
10.9
17.5
20.6
5.0
15.1
16.8
36.1
24.1
25.3
28.2
21.3
45.0
13.7
13.3
48.6
29.3
11.7
39.2
37.1
26.7
8.4
38.3
34.0
23.7
24.0
13.1
17.1
6.5
19.9
22.7
* RoE Contribution = Net Profit of Sector / Index Average Net Worth
Source: Capitaline, MOFSL
February 2020
39
 Motilal Oswal Financial Services
Thematic | India Inc. RoE
Downtrend Era: 2008-19: Decline in RoE of heavyweights – O&G, Metals
and PSBs – takes a toll on index RoE
Three sectors (Global
cyclical, PSBs and Telecom)
accounted for 1000bps (out
of 1320bps) decline in index
RoE over FY08-19
Over the period, RoE of heavyweights such as Oil & Gas and PSBs softened,
leading to a fall in index RoE. Despite this, Oil & Gas remains the primary
contributor to BSE500 RoE – at 2.3% in FY19 (of 9.5% index RoE) and 4.9% in
FY08 (of 22.7% index RoE).
Of the 1,320bp decline in RoE, three sectors accounted for 1,000bp (Global
Cyclicals – 500bp; PSBs – 360bp; Telecom – 140bp).
Rising competitive pressure in Telecom sector significantly dented its RoE and its
contribution to index RoE. Telecom drove a 1.4% decline in index RoE.
All sectors, except for Insurance and Media, witnessed softening in RoE.
However, their contribution to index RoE was mixed.
Exhibit 69: RoE declines across sectors (FY08-19, %)
Particulars
Global Cyclical
Metals
Oil & Gas
Domestic Cyclicals
Automobiles
Capital Goods
Chemicals
Diversified
Infrastructure
Misc
Real Estate
Retail
Utilities
Defensive
Cement
Consumer
Healthcare
Media
Retail
Technology
Telecom
Textiles
BFSI
Banks - Private Sector
Banks - Public Sector
Insurance
NBFC
Grand Total
FY08 ROE
FY08 ROE
Contribution
8.6
3.7
4.9
5.1
0.9
1.1
0.3
0.1
0.1
0.5
0.8
0.0
1.3
4.8
0.6
0.9
0.7
0.0
0.0
1.3
1.0
0.3
4.2
0.7
2.2
0.2
1.1
22.7
FY19 ROE
FY19 ROE
Contribution
3.6
1.3
2.3
2.0
0.2
0.5
0.2
0.0
-0.1
0.4
0.1
0.0
0.5
2.8
0.2
0.8
0.5
0.1
0.1
1.6
-0.4
0.1
1.1
0.9
-1.4
0.2
1.4
9.5
Change in ROE
(FY08-FY19)
-19.9
-10.2
-21.7
-11.8
-6.4
-26.6
-23.9
-2.1
-40.9
-11.8
-3.3
-29.4
-12.2
-15.4
0.2
-22.9
-8.0
-41.8
-15.5
-3.3
-28.0
6.0
-5.1
-13.2
Change in
Contribution to
Index RoE
-5.0
-2.4
-2.6
-3.1
-0.6
-0.6
-0.1
-0.1
-0.2
-0.1
-0.7
0.0
-0.8
-2.0
-0.4
-0.1
-0.2
0.0
0.0
0.2
-1.4
-0.2
-3.1
0.2
-3.6
0.0