In the middle of demonetisation of currency heist many analysts had downgraded Indian corps earnings to 5% for the 2017 financial year. Well, there is no change to it as couple of months back too these same analysts were expecting earnings not to grow by more than 5% in 2017.

Is a company that grows its earnings 20% is a good company? You might be thinking company that can grow 20% earnings might be high quality business as its earnings are growing at stronger level. But in my opinion looking at earnings growth in isolation is a big mistake to judge whether the business is of high quality or not. Imagine a business that reported Rs 200 crore profits last year and Rs 240 crore this year (growth of 20%), but in doing so they reinvested Rs 2000 crore in the business. A return of 2% on the incremental capital. This low grade returns on incremental capital makes this business a poor quality even though its earnings are growing by 20%.

It is important that businesses should manage to achieve at par or more returns then its cost of capital to create any value for the business and its shareholder. But there might be time where businesses might be in the investment phase, where they are investing today to achieve those higher returns in the future. Understand their investments and expectations from it before investing and judge their expectations rationality.

In my view there are 3 main categories of businesses to understand this framework.

  • Businesses that are producing higher returns on their capital and requiring lower capital requirements.
  • Businesses that need higher capital requirements for growth but also produce decent returns on them, and
  • Businesses that need capital but generate substandard returns on them.

The first category one are the one where you don’t need to invest lot of capital to bring growth in the business. These are typically the businesses with the pricing power. These are the businesses which are capable of passing their cost to their customers. They poses those competitive edge within their business model. The best example to give here will be the businesses like CRISIL, CARE and Coal India.

indiabullsThe second category businesses are also attractive to invest but they need extra incremental capital to grow. NBFC’s and banks are the good examples which fall in this category. Indiabulls Housing Finance is our favourite stock that also falls in this category. The only thing you need to keep an eye on is that the businesses in this category should earn returns above its cost of incremental capital.

The third category businesses should be avoided to invest. These businesses have material reinvestment need and they fail to earn satisfactory returns. There are many big names which fall in to this category. Reliance Industries is the first name that comes in my mind and then Tata Steel, BHEL and Bharti Airtel. Reliance Industries will be reinvesting approximately Rs 20,000 crore in its business this financial year and still will be earning 6% less than what they reported in 2016. Many will argue that this is because of its biggest investment initiative in Reliance Jio this financial year. But if you got the chance to look in the past, they had reinvested thousands of crore back into the business which had generated substandard or below their cost of equity returns, at least from the past five years.

So earnings growth is not always good for the businesses, especially the ones which cannot cover their cost of equity. That same growth becomes destructive for investors as it doesn’t adds any value to the business.

Aziz Dodhiya is the chief investment officer for the Valueoperations funds which operates in the Indian market as an FPI (Foreign Portfolio Investor). We do not offer any personal advice to buy or sell any stocks and the views that are shared by Aziz might not incline to your personal investment strategy and this is the reason we tell you to take professional advice before going ahead with our views.