Insight Into Wealth Creation
THEME/WEALTH
| Observation: The market as a whole actually created no wealth overall during the five years. The net gain in market capitalisation of the broad market, comprising several thousand companies, was a meagre Rs 13,926 crore. But wealth-generating companies - 71of them - added more than Rs 2,17,180 crore in terms of market-cap growth. |
| Net-net: Several thousand other companies destroyed an equal amount of wealth to almost neutralise the efforts of the wealth-creating group. Says Raamdeo Agrawal, joint managing director of Motilal Oswal: "Barely one in 100 companies created wealth during the last five years." He concludes that there has been a huge misallocation of capital in the economy, possibly due to a skewed tax incentive structure. |
| The findings, however, need to be seen in their proper context. To say that only one in 100 companies created wealth is not the same as saying that only one per cent of the corporate sector performed satisfactorily in terms of profits or growth. Its just that the market may not yet have rewarded those that did. But that's where company managements need an understanding of how wealth is really created. |
| The Motilal Oswal study suggests that there are five forces that create wealth for shareholders. These are: high return on equity, increasing capital employed, growth, cost of capital and the margin of safety - the last being the payback period on stocks at a given market price and expected level of free cash flows in future. The lower the payback period, the higher the margin of safety for the investor. Let's take each of these forces by turn. |
| Return on equity: The study shows that the greatest wealth creation happened with companies reporting an ROE of over 35 per cent during the five-year period. Over half the market-cap growth created by the 71 companies in the wealth-creating group was accounted for by just 12 companies. |
| Increasing capital employed, with high RoE: Wealth creating companies tended to employ more capital, but the real deadly combination was one where a high ROE is combined with increasing capital employed. The study found that the top 10 fastest wealth creators showed a CAGR (compounded annual growth rate) in capital employed of 20-135 per cent. Not all increases in capital employed will create additional wealth: to do that, the profitability of incremental capital employed has to be more than the cost of capital. The larger the margin over cost, the greater the wealth created by increasing capital employed. |
| Growth: If a high RoE starts the wealth creation process and increasing capital employed gives it size, it is the growth in free cash flows that hastens the wealth creation process. Faster the growth in free cash flows, faster the wealth creation; as seen in tech stocks during 1999 and 2000. |
| Cost of capital: Unlike the first three forces of wealth creation, the fourth force, the cost of capital - or interest rates - are external to a company. Wealth created should normally be inversely related to the level of interest rates in the economy. The lower the interest rates, the higher is the present value of future corporate cash flows. This, in turn, should result in higher share prices given a certain level of expected cash flows. |
| Margin of safety: The fifth force of wealth creation is the margin of safety - again external to a company because it involves an investor's risk perception. Motilal Oswal defines the margin of safety - or the payback ratio - as the market cap of a company divided by the sum of expected profits for the next five years. The sum of profits can be deduced from current earnings or projected earnings, but the idea is simple: the lower the payback period, the higher the margin of safety for investors. |
| Motilal Oswal reckons that any payback ratio of more than two (that is, market cap divided by next five years' profits is more than two), reduces the margin of safety for the investor. This, in turn, could impact wealth creation since investors will not see an advantage in holding the share. Companies in this category should, therefore, work on improving profitability to bring back the margin of safety. |
| Among other things, the Motilal Oswal study found that businesses that were more focused (that is, not widely diversified) produced more wealth than the rest. Growth in the same franchise does the same. Also, businesses with strong customer or service franchise tend to create more wealth than the others. Some 83 per cent of the wealth creating 71 companies were in these two categories. |
| This article appeared in the Indian Management magazine issue of June 2002. |