Higher return on equity: An edge for Indian markets

Ability to deliver higher returns and margins to help India Inc stand out among emerging market peers; market to sustain premium valuations

Premium valuations of Indian equities have come under cloud after a disastrous earnings show in FY15. Global investors “Modified” their view on Indian markets last May after the National Democratic Alliance (NDA) government came to power. Even though there was little change in corporate earnings, markets were re-rated and one-year forward multiple inched higher than the long-term average of 16 times. Can Indian equities command such a premium in the face of poor earnings growth seen in FY15?

In absolute terms, perhaps not. But compared to other emerging markets, Indian equities continue to look robust. While earnings growth is important, a key metric to measure how profitable a company has been for its investors is return on equity, or RoE (net profit as a percentage of net worth). A higher number indicates that the company is more efficient in utilising shareholders’ funds.

If RoE is a measure of capital efficiency and profitability, with India’s RoEs higher than other emerging markets (see table), it deserves a premium valuation. India’s RoEs have averaged at 16 per cent over the long-term, which declined to a decadal low of 13.8 per cent in FY15. In 2014, the RoE of benchmark Sensex was at 16.17 per cent, while that of Shanghai Composite Index was at 12.96 per cent, Brazil at 5.06 per cent and Taiwan was at 11.53 per cent.

Higher returns on equity are indicative of companies with high margins and better returns. What is currently plaguing Indian companies is weak demand. Jonathan Garner, chief Asia and emerging market strategist, Morgan Stanley, says: “India is trading at 16x one year forward earnings on consensus and 13 times on our estimates for FY17. India trades at reasonable premium to rest of the emerging markets because of its high return on equity, which is currently at 16 per cent. The rest of the emerging market RoE is below 11 per cent.”

India’s RoEs are relatively higher compared to the rest of the emerging markets pack not because of sparse competition but because margins are higher relative to others. Typically, commodity companies and infrastructure companies command lower margins and, therefore, have lower RoEs than services or consumer companies.

Corporate India’s RoEs are higher because of diversified mix of companies on the benchmark indices. The weightage of banks is 21.54 per cent in the Sensex, while auto has a weightage of 10.63 per cent and IT is at 15 per cent. Nitin Jain, head of capital markets at Edelweiss, says, “India is a well-diversified economy with consumer, technology and financial services having a significant weight on the benchmark indices. Add to that the risk free rate.” The sharp slowdown in corporate India’s earnings in FY15 was driven by a sharp slowdown in sales growth, which dropped to two per cent year-on-year in FY15. Operating margins, a key measure of profitability, held up well and remained flat at 14.2 per cent in FY15, says IIFL’s Prabodh Agarwal in a note.

Sankaran Naren, chief investment officer at ICICI Prudential Asset Management, adds, “RoEs are lower in commodity businesses, while they are a lot higher in consumer companies, which is why these companies command a premium. We think the market is fairly valued at this point of time and profitability will pick up in H2 or next year.”

Notably, with global commodity prices, including crude oil, expected to remain soft and in India interest rates on the downtrend, Indian companies will gain from lower costs, which should partly reflect on their profitability and consequently return ratios. This in itself should play in favour of Indian markets unlike the case with commodity-producers like Russia and Brazil.

High RoEs will help sustain premium valuation of Indian equities till earnings recover. And once earnings recover, it will further push up RoEs, possibly leading to higher PE multiples for the Indian markets.