Let us say you want to invest in a business that can earn you good returns. Now, there are so many businesses in which you can invest your money. Here is where major investors get stuck since there are end number of options and you don’t know from where to start. For any business to function good and earn you good returns, the sector all together should perform well. Different sectors have different ways of operations all together. It is rarely found that a business goes against its sector and become successful. For example, in Textiles, all the businesses conduct their transactions on credit basis because this is how the sector functions altogether. You will rarely find any textile business to operate on cash basis. Thus, an investor should first find a good sector and once he finds it, then he should start his deep research so as to find a good business in that particular sector to invest his money.
Here again the investors get stuck so as to what is a good sector and a bad sector. A good sector is the one that can generate returns more than its cost of capital. If the sector is not able to beat its cost of capital, then investing in any business of that sector is not worth it. Cost of capital is the opportunity cost of making a specific investment. Thus, if your investment returns is less than the other opportunity, then one will invest in that opportunity rather than the business of that sector since it is generating you more returns.
I think Nifty returns can be considered as a good opportunity cost of capital because a sector should atleast beat the indices. If they are not able to generate more than the index, then its better for an investor to invest in the Nifty rather than a business. Thus, I have calculated 1 year, 5 years, 7 years and 10 years Nifty 50 rolling return from 1996 to 2020 to get the opportunity cost of capital.
Thus, the opportunity cost of capital turns out to be 12%. In order to get into details of calculation in excel sheet, click on the link given at the end of the blog.
Now, a sector should give more than 12% return in order to beat the nifty index. If a sector is able to generate more than cost of capital, that means the sector is earning economic profit. Economic profit is different from accounting profit. It is the profit earned over and above the cost of capital. Therefore, I’ve calculated economic profit of Pharmaceutical sector. Let us understand how.
First of all, I have calculated cash ROCE of all companies beyond Rs.100 Cr market cap from FY09 to FY20 that turns out to be 76 companies.
Cash ROCE= Cash Flow from Operations/(Debt+Equity)
Here, cash ROCE is calculated using CFO rather than EBIT, so that we get ROCE on cash basis and not on accrual basis. After we are done with calculation of cash ROCE of 76 companies of each year from FY09 to FY19, we will calculate economic profit by subtracting each cash ROCE by 12% i.e. the nifty cost of capital calculated earlier. Once we get the economic profit of every company for every year, we will take out the average of 10 years economic profits of all the companies individually. So, now we have average economic profit for every company. Next step we’ll do is that we will again take the average of the average of economic profit of all companies just calculated in the previous step. That comes out to be -2% i.e. cash ROCE is 10% (10%-12%=-2%).
Now, if we see the data points of all the companies, we will see that there are only 6 companies out of 76 that earned negative cash ROCE. So if we use a filter to remove these companies with negative ROCE and then again take the average of average of economic profit, the answer comes out to be +2% i.e. cash ROCE is 14%.
To understand the calculations done over excel, please click the link given at the end of blog.
My observation upon economic profit coming out to be 2% in Pharmaceutical sector is that the sector is not extraordinarily good because it is able to generate only 2% of economic profit but it is reasonably a good sector to look forward to. You can now start researching even more deep into this sector and find some mind-blowing pharma companies to invest and grow your money.
Link of the above calculations:
https://drive.google.com/drive/folders/1vK9PxJU8YJBsHu0QrOFGJZe7gI5jEATI
Note: Debt in calculation of cash ROCE does not include current portion of long term debt.
Written by- Astha Sundarka
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