March 2019 Newsletter

<This is an extract from our March 2019 newsletter to clients>

Return on capital employed – The Promoter angle

Recently, Naresh Goyal stepped down from this leadership role at Jet Airways. The media was buzzing with the story of a travel agent turned airliner who was at the forefront of the air travel boom in India. If you think of it, the air travel industry has grown multi-folds over the last couple of decades. However, Jet Airways has failed to create wealth for its shareholders. This should serve as an example for those who believe that just because an industry will grow, shareholder returns will follow. But, the focus of this letter is on another aspect.

Imagine – You started a business and ran it for many years during which the business made big losses, you would have ended up under a lot of debt and would have to eventually sell off your assets to pay these liabilities. However, businessmen like Naresh Goyal, Venugopal Dhoot, Ruia, etc. are examples where your business goes bankrupt in couple of decades and yet the promoter amasses huge wealth over this period. I am not saying that you think of this phenomenon as a scam or siphoning away of funds. But, think of this as a way to evaluate businesses and stay away from a particular type of company that we will discuss later in this note. I am trying to think from a promoter’s perpective and not from that of a retail shareholder.

So what is Return on capital employed?

The academic formula is Earnings before interest and taxes divided by the average capital employed. The capital employed includes own funds (shareholder) and borrowed funds (lender).

Particulars Company A Company B
EBIT (Rs. Crores) 100 300
Avg. Capital Employed (Rs. Crores) 500 2,000
Return on capital employed 20% 15%

 

Company A is earning as much as Company B but the capital it is using is much lower than the capital Company B is using. This shows that Company A is a better business. Now let us add a twist to this example.

Particulars Company A Company B
EBIT (Rs. Crores) 100 300
Avg. Capital Employed (Rs. Crores) 500 2,000
Shareholder’s Funds 500 100
Borrowed Funds 0 1,900
Interest Cost 0 228
Profit After Tax 70 50
Return on capital employed 20% 15%
Return on equity 14% 50%

 

Company A has borrowed nothing while Company B has taken a big loan at 12% p.a. and invested it in the business. Both of them have paid tax at 30%. Because of this leverage, the return on equity for Company B has shot up to 50% against 14% of Company A.

Return on equity

Return on equity is the Profit After Tax divided by Shareholder’s Funds. Thus, the loan has boosted returns for the shareholders. Now, assume that you were the promoter of Company B. You started the company with Rs. 1 Crore of your own investment, kept re-investing the profits and came with an IPO, selling 25% of your stake to the public for Rs. 50 Crores. The you took a Rs. 1,900 Crores loan and pushed the business into the big league. Now, 75% of the profit belongs to you. Everything that you are earning is on the Rs 1 Crore that you had invested.

While the ROE for the investors is 50%, for you it is astronomical! And you have already made a fortune by selling 25% to the public. That amount is being invested into real estate, restaurant businesses, etc. You have created multiple sources of income for yourself. And on top of that, your family and you are withdrawing handsome salaries from the business. Many promoters also indulge in related party transaction and pay family members rentals, leases, etc.

A bad phase strikes

 

Particulars Company A Company B
EBIT (Rs. Crores) 30 100
Avg. Capital Employed (Rs. Crores) 500 2,000
Shareholder’s Funds 500 100
Borrowed Funds 0 1,900
Interest Cost 0 228
Profit After Tax 21 (128)
Return on capital employed 6%
Return on equity 14%

 

Soon, the industry faces headwinds and the company goes into losses for 3-4 years in a row. To keep the cashflows running, you keep taking more and more debt hoping things will turn around. But things don’t turn around and the company declares bankruptcy. You and the company are separate legal entities, so nothing happens to your wealth. Yeah, you have lost the business but then you are affluent enough and have many other sources of income now. Your lifestyle doesn’t change, but the shareholders of your company see their investments go down to zero.

In this way, despite being part owners of a company the promoters and the retail shareholders get different results from their investments. Yes, the promoter had a vision and he took the risk, executed his vision and deserved to make money out of it. But then a 10% ROCE for him is good enough while for a retail shareholder he will desire at least a 15% ROCE.


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