It isn't always easy for a savvy investor to make the right decision: he usually wades through a complex set of numbers and ratios before arriving at a conclusion. However, what helps him in this process are two parameters — return on capital employed (RoCE) and return on equity (RoE).
Empirical studies have shown that companies that do well on these two counts typically command premium valuations.
These parameters offer great insights into identifying undervalued or overvalued companies, helping an investor immensely to take the right call. These two measures tell how profitable a company is in terms of investments made in it or how efficiently it is using its resources.
While the RoCE measures profitability against the entire capital — debt and equity — invested in the business, RoE measures the return to the equity shareholder. These parameters take into account companies' capital structure as well as operating performance and, hence, are more comprehensive.
"Return ratios basically tell you how much a company is earning on the investment made by it in the business. If these ratios are lower than the prevailing bank rates, then the company is better off putting that money in a bank instead of investing it in business."
In IT, leader TCS with over 55% RoCE and 44% RoE is trading at a P/E of 23.7 and P/BV of 11.3. In comparison, Tech Mahindra with its RoCE and RoE above 40% — higher than that of Infosys, Wipro or HCL Tech — is available at a P/E of 16.5 and a P/BV of 5.3, making it relatively undervalued among its peers.
Similarly, Bajaj Corp with an RoCE of 74% and an RoE above 57% is trading at a P/E of 22.9 and P/BV of 6.6. In comparison, peers like Marico, Dabur, Godrej Consumer, Emami, P&G Hygiene and Gillette India are trading at a higher valuation multiples, although their return ratios are modest. Colgate-Palmolive and HUL have better return ratios, but they are already captured in their higher valuation multiples.
Source:ET
Empirical studies have shown that companies that do well on these two counts typically command premium valuations.
