Return on Net Worth

What's the first thing you look for when you need to put your savings away in a fixed deposit in a bank?

Returns? Bullseye!

If you have put Rs100 in the fixed deposit in and have Rs110 in your account at the end of the year, your return is Rs10. This extra Rs10 is what induces you to save.

 

What about your investment in the stock of a company?

Remember, investing is like owning a business. You should ask how much return the company makes on its capital. After all, the higher the return, the more money you earn on your investment. How do you measure returns?

Before going into how returns are measured, we need to know what we, as shareholders, have at stake in a company...

Net worth is funds that the shareholders own - their equity. It represents the capital contributed by the shareholders and the accumulated net profits after paying out dividends (retained earnings). This is what belongs to the shareholders and is re-invested into the business.

Dividends are excluded from capital because they entail a cash outflow for the company, and this amount is not re-invested into the business.

 

And how do you measure the returns earned?

Return on Net Worth (RoNW) is defined as Net Profit divided by Net Worth. Simply put, it shows the returns that the shareholders have earned on their funds utilised in the business. Do you still wonder why RoNW is a favourite return ratio with shareholders? It examines earnings in relation to capital.

The stock market is dotted with countless instances where high return companies have yielded higher stock returns. Taking the example of Hindustan Lever vs. Colgate...

HLL (Rs in crores)	1999	1998	1997	1996
RoNW (NPM 'turnover' leverage)	51%	48%	44%	37%
Incremental RoNW	7%	7%	20%	-
Stock Returns	35%	20%	71%	-

 

Colgate (Rs in crores)	2000	1999	1998	1997
RoNW (NPM 'turnover' leverage)	17%	16%	27%	31%
Incremental RoNW	11%	-43%	-11%	-
Stock Returns	7%	-24%	9%	-

Hindustan Lever has consistently earned better returns on shareholders' funds than Colgate. Thus investors find it a more lucrative deal to invest their money in HLL than in Colgate. This ultimately reflects in the companies' stock prices. HLL's stock has turned in much higher returns than Colgate's, over the same time frame.

 

So where has HLL scored over Colgate?

After all, both these companies have similar business profiles. They cater to a similar class of consumers. Both of them boast of MNC parents. And they both have strong brands in the country.

The answer to this lies within the Return on Net Worth ratio itself. Dig deeper and this ratio offers a good perspective on the business and a company's prowess in conducting it. We probe into the RoNW ratio using a little arithmetic...

Return on Net Worth	= PAT / Net Worth
	= (PAT/Sales) x (Sales/Assets) x (Assets/Net Worth)
	= (profitability) x (efficiency) x (leverage)

Merely splitting the basic ratio into its various possible components reveals a treasure of information and insight that it can provide on a company's operations.

For the RoNW to be higher, a business has to score on three crucial aspects - profitability, efficiency and leverage. Now if we break up the RoNW of both HLL and Colgate into these three components, this is what we get.

HLL	1999	1998	1997	1996
Net profit margin (NPM)	10%	8%	7%	6%
Sales/ Total Assets (turnover)	4.78	5.21	5.75	5.17
Total Assets/Net growth (leverage)	1.08	1.16	1.15	1.23
RoNW (NPM* turnover*leverage)	51%	48%	44%	37%

 

Colgate	2000	1999	1998	1997
Net profit margin (NPM)	5%	5%	8%	8%
Sales/ Total Assets (turnover)	3.65	3.34	3.42	3.66
Total Assets/Net growth (leverage)	1.02	1.02	1.02	1.02
RoNW (NPM* turnover*leverage)	17%	16%	27%	31%

 

Profitability

Do we really need to state the importance of profitability in a business? Profitability reflects whether a company is able to sell its goods and services competitively in the market.

That's where the power of brands, distribution, pricing, etc. of the companies come in. Hindustan Lever has an Operating Profit Margin (OPM) of 15% while Colgate has an OPM of about 10%. This despite Colgate having the strongest presence (so far) in a niche segment. Higher profitability contributes to better returns.

 

Efficiency in the use of capital

Put simply, an efficiency ratio is indicative of how hard the company has put its assets to work. The assets must translate into sales. After all isn't that the very idea in installing the asset? Hindustan Lever generates far higher sales on its assets than Colgate does.

At this juncture, it is important to point out that the issue of efficient use of assets assumes a lot more importance for capital intensive companies. They often lose out on this parameter and have to contend with poor returns.

Take the instance of Reliance Petroleum, which has set up a world class refinery at a cost of over Rs14,000cr. Fair enough. But the shareholder isn't interested in setting up a plant - world class or otherwise. What matters to him is the revenue stream that can be generated by the asset built at such a huge cost.

What happens if the plant does not operate at its capacity? No sales are generated but the company anyway has to pay interest worth Rs960cr and depreciation worth Rs687cr on the assets annually. It does not require advanced calculus to figure out that returns would definitely suffer.

 

Leverage

While competent operations hold the key to better returns, the mode of financing the operations and assets has a bearing on returns too. As we discussed previously, there is a fair amount of science involved in choosing the appropriate mode and mix of financing.

A higher component of debt in the capital structure normally results in higher returns. This is called the impact of leverage. Colgate and HLL are on a similar plane on this parameter.

 

Taking stock...

Returns reflect the level of profitability, efficiency and the impact of leverage. A company that has been able to deftly score on all these parameters enjoys the best returns.

The stock market isn't blind to returns. There is a distinct positive correlation between incremental Return on Net Worth and the returns on the stock, as is evident from the first table.

Stating what should seem very obvious by now, the higher the return, the better.

 

But how high a return is high enough?

On the higher side, there is no limit to how high a return can be or ought to be! J

But on the lower side, there is a threshold level of return that the company must earn. And that is the `risk premium'.

The crucial difference between savings and investments is 'risk'. When you decide to invest, savings assume the form of risk capital. Having said that, risk is a matter of choice, and there is a leveller called the risk premium that balances the deal for investors. The returns generated by the company should at least compensate for the additional risk that you are taking by investing in the company.

 

Returns: what they do not tell us?

Return by itself tells only part of the story - the happy part. There is a vital something that is missed out, and that is the concept of 'cost of capital'. Any business has to pay for the use of capital and returns do not account for this cost. At the end of the day, what finally accrues to the business is the return less the cost of capital.

That brings us to the concept of 'economic value added', which is nothing but returns minus cost of capital - and is a fair representation of what is finally and ultimately gained (the 'take home' as the common man understands it) from the business during a given period. The higher the economic value added, the more valuable the company.

But that's another episode by itself...