Losing shareholder value

Regrettably, the story is very different. Yes, markets were down between April 1995 and March 1998. But in the last four years, most listed companies in India have destroyed corporate value. And despite overall bearishness, companies that have added corporate value have been amply rewarded by the market.

Modern corporations require outside finance. Those willingto put up these funds expect a minimum rate of return. Irrespective of whether pre-contracted (for debt instruments) or residual (for ordinary shares), the returns have to be measured against the opportunity cost of capital, or what the investors would have earned in their next best line of deployment.

Some critics argue that such an approach to measuring corporate value is too finance-centric. According to this view, corporate value can also be added by building brands, having better supply chains, focusing on quality creating franchises and motivating a company’s human resources. True enough. But at the end of the day, all this must be reflected in a company’s cash flow. There are two ways of measuring corporate value creation — the somewhat broad and the relatively narrow. The former is economic value added (EVA). Developed by Stern, Stewart & Company, EVA is the residual income after charging for the opportunity cost of capital provided by lenders and shareholders. EVA increases if:

Net operating profit after taxes is profit before interest and tax (PBIT) minus tax. It is somewhat more difficult in India to obtain an accurate number for the true cost of capital.

A caveat is in order. If a company is undertaking large-scale capital expansion and is in a stage where the project is either incomplete or not yet fully geared to generating top notch returns, then it could easily suffer from negative EVA. However, if a company’s EVA is negative over a number of years then something is clearly wrong with its use of capital. In any case, not too many companies in India can use this caveat to explain their value losses over the last four years.

The more narrow measure of shareholder value creation is return on net worth (RONW). It is profits after taxdivided by the shareholders’ wealth in the company, ie, paid up capital plus free reserves. This measure nets out the pre-committed payment obligations to creditors, and focuses only on the wealth created for the residual claimants. If the risk-free yield in the long-term government bonds is 12.5 per cent and a company’s RONW is 9 per cent, then its shareholders have lost hugely. A benchmark RONW is return on risk free long term government bonds plus a suitable risk premium for that industry. This study uses a benchmark RONW rate of 20 per cent — 12.5 per cent as risk-free return on long-term government bonds plus 7.5 per cent as equity risk premium.

The results are derived from two samples from the corporate database of the the Centre for Monitoring the Indian Economy (CMIE). These are:

The samples ignorebanks, development finance institutions (DFIs) and non-banking finance companies (NBFCs) due to the quality of financial disclosure. The time-frame is the four years from March 31, 1995 to March 31, 1998.

These 130 companies rank among the `Who’s Who’ of the Indian corporate sector. On March 31 1998, they accounted for almost 50 per cent of total market capitalisation. Between March 31 1995 and 1998, their sales grew at a compound annual rate of 14 per cent. On March 31 1998, their combined sales accounted for over 35 per cent of the total sales revenue of all 4,985 listed companies of the BSE. These are the bluest of Indian blue chips.

At a 20 per cent cost of capital, these 130 companies lost Rs 36,219 crore in EVA between 1994-95 and 1997-98. At a 20 per cent RONW benchmark, they lost pure shareholder value of Rs 12,490 crore. For every Rs 1,000 of sales, they lost anything between Rs 54 and Rs 35 in value measured by EVA, and Rs 19 by RONW.

Each year saw loss in aggregate corporate value, the worstbeing 1997-98. Forty-eight gained in EVA and earned RONWover 20 per cent; 65 lost EVA and earned RONW less than 20 per cent. Their loss in EVA far outweighed winners’ gains.. Most of the corporate sector has lost value in terms of EVA and RONW.

Despite these losses, India has great corporate value creators like HLL, ITC, Bajaj Auto, VSNL, BHEL, Castrol, Colgate Palmolive, Asian Hotels, TVS-Suzuki and Punjab Tractors.

Some industries have been creating value: auto ancillaries, two-wheelers, fast moving consumer goods, cigarettes, computer software and hardware, compressors, pharmaceuticals, electrical machinery, generator sets, internal combustion engines, machine tools, hotels, and paints. Likewise, some industries are losing corporate value hand over fist. The two most notable are textiles and iron and steel.

Bourses are very good at recognising both growth and reduction in shareholder value. For Group A companies, changes in RONW alone explain 43 per cent of the changes in real market capitalisation,adjusted for the movement of the BSE-200 index. One moral stands out. Even in the post-liberalisation era, companies have been far too wedded to capital expansion, and less to sweating capital to create corporate value. The lure of new projects is still more attractive than concentrating on getting the best possible return on capital that is already employed.

Edited excerpts from a CII study, `Are Indian Companies Losing Shareholder Value?’ by Omkar Goswami, Karthikeyan and G. Srivastava