Monday 5 December 2011

Significance Of High Return on Equity (ROE) in Indian Context

Legendary Warren Buffet opined in annual report of Berkshire Hathaway in 1979 that 

" the primary test of economic and managerial performance of an enterprise is the achievement of high earning rate on equity capital employed (ROE) (without undue leverage and accounting gimmickry) and not the achievement of consistent gains in earnings per share. In our view many businesses would be better understood by their shareholder owners as well as the general public, if management and financial analysts modified the primary emphasis they place upon earning per share."

This unequivocal affirmation my Mr. Buffet that ROE is one of the most critical parameters to identify the quality of business is supported by many other great investors.

So let me first start with the definition of Return on Equity.

ROE = Net Income/ Shareholder's average equity during the period.

In other words, ROE signifies the returns earned on shareholder's money, a very important metrics to keep tab of a company indeed!

This led me to dig deeper in the context of Indian market to identify companies having high ROE (>25%) and reasonable market capitalization ( > INR 1000 Crores). I consciously decided to ignore smaller companies, but more on that later! The objective of the exercises was to understand whether there exists any common thread that binds all these companies leading to higher ROE.

Based on the edelweiss database, i found that there are 112 such companies that have market capitalization of 1000 crores and higher and ROE in excess of 25%. Surprisingly, there is a discernible pattern in the list. Around 80% these companies have enjoyed some "moat" or "sustainable competitive advantage" leading to higher ROE and hence premium valuations in most of the cases. 

Companies having Strong Brand Recognition:

Almost 33% of companies belonged to this universe. These companies themselves are formidable brands ( like Consumer side:Dabur, Emami, Titan, VIP, Bata, Industrial side: Exide, Crompton, Alfa laval) or have products that have immense brand recognition (i.e Nestle- Maggie, Nescafe; Pidilite: Fevicol, M-seal' Zydus wellness: Sugar free, Nutralite;)

- Most of the companies are market leaders by a big margin in respective
- These companies have established channels for pushing the product/brand
- They enjoy high net profit margin
- Many of these companies enjoy substantially higher ROE than that of their competitors (e.g. Asian paints has ROE of 42 % while that of the nearest rival is 23%, Exide ROE -31% as compared to 24% of nearest competitor)

Companies Operating in Natural Monopolies/Oligopolies:

This universe consists of mainly government owned/promoted companies that are involved in businesses which are either regulated natural monopolies or government controlled businesses. Companies like Coal India, NMDC, Gujarat State Petronet Limited, Indraprashta Gas Limited, BHEL, Enginners India Limited belong to this list. Some of these companies have very strong barriers to entry such as GSPL and Indraprastha Gas because these businesses are natural monopolies. Others such as NMDC and Coal India operate in areas where private sector enterprises are not allowed to do business.

- Most of the companies in this business are regulated and hence prone to whims/fancies of government and regulators
- Many companies have very inefficient operations however they are able to pass on the cost to the users because of lack of alternative for the user/customer
- Such companies have very strong balance sheets with many having huge cash reserves

Companies Having Niche Business:

This group comprised of companies that have carved out their own niche and hence are less prone to competitive intensity. The group consists of companies like 

Balkrishna Industries- One of the world's largest manufacturer of Off -Highway tyres.
Shriram Transport Finance: Company has pioneered commercial vehicle finance in India and is India's largest commercial vehicle finance company.
Muthoot Finance: India's largest gold loan company.

DB Corp: India's largest print media conglomerate. It is the only print media company focusing on vernacular language newspapers.

Most of niche businesses operate in unorganised manner at small scale, however above companies have bucked the trend and have established themselves as clear market leader in their respective businesses.

Companies having Asset-light business models:

Last group consists of companies that have asset light business models. It is noteworthy that, in most of these companies, value creation happens through intellectual inputs. Companies that belong to this group are Infosys, Wipro, Tech Mahindra, CRISIL and pharmaceutical companies like Astrazeneca, GSK pharma, Cadial Health care, Torrent pharmaceuticals etc.

Some of the characteristics of these companies are
- They derive competitive advantage through intellectual capital i.e. quality of 
  human resources, patents, path breaking business models etc.
Most of these businesses are asset-light and does not require substantial 
  tangible capital. Hence these businesses, by nature, are high ROCE 

Takeaways from Analysis:

Here are some important takeaways on my analysis of high ROE companies
  • If the company has grown to a reasonable size in terms of revenues over a period of time, and has consistently maintained high ROE, without resorting to excessive debt, chances are that company has "moat" and hence represents a strong business
  • However the same can not be said for smaller companies, as many small companies start with high ROE but as they grow in scale, competitive intensity increases and scalability of business and business model is tested. Many companies lose their way at this stage and they become "survivors" instead of "market leaders"
  • Typically, market puts a substantial discount to companies that enjoy monopoly due to government controls even though such companies have high ROE and strong balance sheet.
  • There is no "silver bullet" in investing and the same is true for ROE is as well. ROE is a critical differentiator between a great business and a mediocre business, however it shall be analyzed in sync with other ratios such as debt/equity, sales/profit growth rate and free cash flow generation.
  • If you come across a company where differential between ROCE and ROE is high, most likely reasons is "leveraging"
  • One shall avoid looking at average ROE for last 5 years, instead one should look for trend in ROE as it may provide insight into the improvement/deterioration in quality of business.


  1. Hi Dhawnil

    I'm following your blog for last couple of days..nice work..every article is pretty neat.
    i also share the similar value investment philisophy.

    GSPL as you pointed out has a natural monoply
    last few days stock has beaten down and at price rs 78 looks attractive from long term perspective..what is your call ?

    1. Hi Sagar,

      Thanks for your words of appreciation.

      Regarding GSPL, I do think that underlying business is very sound as use of gas in India is continue to grow due to number of advantages of natural gas has over other fossil fuels. I am also associated with gas sector as a professional and hence privy to the ground realities of this sector and business. Currently GSPL has state wide gas pipeline network in Gujarat there is almost no competition (except for GAIL which has trunk pipeline going in some parts of the state). However someone has rightly said that a wonderful business may not be a wonderful investment. I have two worries on GSPL. Following are the positive and negative aspects for GSPL

      - It is a natural monopoly and has very strong business economics
      - Gas market in India is at nascent stage and has tremendous opportunity to grow.
      - Low maintenance Capex required
      - Negative working capital for GSPL indicates very effective cash conversion cycle
      - GSPL has won bids for 3 major pipelines that can make GSPL 4-5 times bigger.
      - GSPL has 35% stake in GSPC Gas,a city gas distribution company which is expanding rapidly. This investment is quoted at cost on the books of GSPL while the actual intransic value from the investment may be substantailly higher.

      - As GSPL operates in natural monopoly, it is a regulated business. However, regulatory regime is relatively new and hence is going through transition phase.
      - In India, sometimes, regulators are not independent and may not work in the interest of the growth of the sector, leading to unsustainable policies and crippled businesses. This is, in my opinion, a major risk.
      - Even though, Government of Gujarat owns 26% in GSPL, it is still considered a state sector PSU. A chairman and MD is appointed from Government of Gujarat. Thus every 3-4 years, there is an issue of new MD taking over, re looking at the policies/business operations. This sometimes may lead to lack of consistent business policies.

      However,in my opinion,current prices have already discounted the negatives. So If you have more than 5 years horizon, it will be a good investment.

  2. Thanks Dhawnil on detailed reply on makes sense.

    Gujarat gas is private company ..are the regulations similar to GSPL applicable to Gujarat gas also ? if yes..why is market paying higher price for its stock ?

  3. Yes, similar regulations from PNGRB will be applicable to t gujarat gas also. In fact, that is one of the major reason for British Gas wanting to exit gujarat gas as they do not see much upside from here on.

    With regards to price Gujarat Gas is commanding premium due to following reasons

    - It is owned by British Gas (an MNC) and maintains highest corporate governance standards.
    - Nature of business is slightly different, Gujarat Gas actually sells gas to customers while GSPL only transmits gas through its pipeline. Hence Gujarat Gas has much higher ROE than that of GSPL

    - Gujarat Gas balance sheet is very strong with low debt to equity and 500 crore of Investments while for GSPL debt to equity is relatively high.

    I hope this answers your question.

  4. Thanks Dhawnil for response. your answers obsolutely gives me lot of clarity. thanks.. I agree with you on nature of GSPL business.Customers(User of gas) and Gas suppliers do agreement on gas supply.GSPL does a open access agreement with customers & suppliers. Accordingly GSPL will reserve the bandwidth of pipeline and is only reponsible to transmit the gas.

    If you agree on my understanding, does this mean GSPL will get fix amount of charge for bandwith even if it doesn't transmit the gas because of shortage ? how much is the bandwidth cost % of total charge ?

    GSPL couple of months back received a order to build three Cross Country Natural Gas Transmission Pipelines, namely: Mallavaram - Bhilwara (1585 Kms) pipeline, Mehsana - Bhatinda (1670 Kms) pipeline and Bhatinda-Jammu-Srinagar (740 Kms) pipeline. Earlier GSPL (with 52% stake) in consortium with IOCL (26%), BPCL (11%) & HPCL (11%).

    Any idea if business model will remain same for these pipelines ?

  5. Hi Sagar,

    Yes, your understanding is very correct. Regarding the fix charge, transmission charges from GSPL has a major fixed component which goes towards servicing the capital investment made in building pipeline. Generally this fixed component varies from 65-80% of total transmission charge. So even if the gas does not flow through pipeline but customer/supplier has bough transmission capacity he will end up paying fixed charges.

    Regarding the 3 new pipelines,GSPL won it through competitive bidding and hence exact transmission charges are not known to me. however,I understand from industry sources that the underlying principle remains same. Hence, in new pipelines once GSPL has won it by bidding certain transmission charge (and appropriate yearly escalation, it can not revise it in first few years. In that sense, GSPL has to abide by the bids that it has made.

  6. Thanks Dhwanil for valuable information on cost structure model.

    10 year history of GSPL tells ROE was less than 10 % before 2009.
    I believe it was because of low availability of you agree ? or was it because of poor govt regulations ?

    Do you see a probability of these scenarios happening again in future and ROE going below 15 % ?

    1. Yes, low ROE was on account of lack of availability of gas flowing through the pipelines. GSPL had built pipeline on open access basis and hence had built 33% capacity in addition to captive requirement.

      In terms of future RoE, it is very difficult to judge. However, considering the fact that Indian gas demand is going to be large for next 10 years and natural monopoly of the business, I expect reasonable RoE for GSPL may be in 18-20% range. However, I also believe that regulator in the sector will make sure no operator earns unreasonable returns and to that extent achieving super normal RoE for GSPL is not a base case scenario.

  7. Thanks Dhwanil ..what is your email id.

  8. my e-mail id is

  9. Hi Dhwanil....

    Great post..

    considering that ROE is significantly effected by it not better to use ROIC as a measure to analyse the eliminates the capital structure and gives the return from core operations...

    or even better....ROE and ROIC can both be compared and the judgement can be made as to whether the returns the company is generating is accruing ti the shareholders or not..

    pleaselet me know your views

    1. Hi Ramesh,

      In my opinion, just relying on ROIC may not be adequate as it does not take into account impact of leverage on returns. Limited leverage is critical for enhancing returns of the shreholders. Hence relying just on ROIC may not give accurate estimate of each rupee invested as equity (shareholder's money). Instead, as you suggested, one should look at both ROIC and ROE in sync to understand what part leverage plays in generating return on shareholders' funds.

      However, what i found through my small research on drivers of ROE, is that companies with strong moat mostly derive their ROE from combination of net profit margin and asset turnover. However if one driver is too prominent, it may command lower valuation sometimes. Case in point, mining companies like NMDC, HZL and MOIL which have 50% NPM but have very low asset turnover ratio (due to huge chunk of cash lying on their balance sheet) and no debt. They command low valuation inspite of very high ROE.