You all had heard a lot about return on equity and its importance while analysing any business on this blog. Return on equity (ROE) is the most powerful metric to assess the value of any business. Let us understand what is incremental ROE and its importance too in analysing any business.

When a company reports profits, most of them do not distribute their profits 100% as dividends to the shareholders for various reasons. They keep that money for the need of working capital, buying new plants and machinery, property, maintenance or if they see any new project where they can fetch good returns. They also keep money in the business to buy growth (M&A activities).

If the management is really good and rationale then they do their homework before going ahead with any activity that we discussed above. Talking and discussing with the management about their new plans and what kind of returns they can expect and how much will it cost gives us a good insight to project future earnings and estimate return on equity to expect from the business. Not everyone can talk to management, but still if we go through media, press release, presentations and also the transcripts of the reporting period, you can compare the figures with what management had in mind.

To explain this concept of IROE (incremental return on equity), let me take you through three businesses, where they all are sitting on hefty cash in the bank and they still do not share profits generously with their shareholders.

Infosys

Infosys 2011 2012 2013 2014 2015
Shareholders Equity 25,976 31,332 37,994 44,530 50,736
Net Profits 6,835 8,332 9,429 10,656 12,373
ROE 26% 27% 25% 24% 24%
Dividends Paid 3,429 2,688 2,397 3,605 5,090
Dividend tax paid 568 438 403 615 1,034
Reinvested in Business 2,838 5,206 6,629 6,436 6,249
Extra Profits generated by incremental capital 1,497 1,097 1,227 1,717
IROE 53% 21% 19% 27%

 

TCS

TCS 2011 2012 2013 2014 2015
Shareholders Equity 24,505 29,579 38,646 49,195 50,635
Net Profits 9,190 10,523 14,076 19,332 20,060
ROE 38% 36% 36% 39% 40%
Dividends Paid 2,740 4,893 4,306 6,267 15,474
Dividend tax paid 459 807 727 796 2,636
Reinvested in Business 5,991 4,823 9,043 12,269 1,950
Extra Profits generated by incremental capital 1,333 3,553 5,256 728
IROE   22% 74% 58% 6%

 

Mindtree

Mindtree 2011 2012 2013 2014 2015
Shareholders Equity 776 957 1,314 1,641 2,012
Net Profits 102 219 339 451 536
ROE 13% 23% 26% 27% 27%
Dividends Paid 10 16 50 104 142
Dividend tax paid 2 3 8 18 29
Reinvested in Business 90 200 281 329 365
Extra Profits generated by incremental capital 117 120 112 85
IROE 130% 60% 40% 26%

 

A quick heads up that we have not included ESOP’s and dilution of equity calculations in the above example.

The incremental return on equity helps us to find out how strong the return on equity will be for the future year (future projections) and will the business be able to sustain its strong returns.

If you look through our eyes, IROE of 6% in the year 2015 by TCS, forced them to pay hefty dividends to keep its shareholders happy and faith in the business. You can dress up that dividend by saying special dividend or silver jubilee dividend or anything else, if TCS would had not paid that dividend it would have impacted to its valuations severely. Looking ahead, as this business is trading at cheap price today, it will be very important to know what final dividend they will declare for this financial year (2016) and how much profits will be retained back into the business to calculate its estimate fair value.

Similarly, Mindtree had retained Rs 365 crore back in the business in 2015. With that money they have done few shopping like buying digital business Magnet 360. To maintain its 27% ROE for the 2016, they have to manage to get 27% return on its incremental capital (365 crore). Unless Mindtree’s 4th quarter comes out with surprise earnings (which we don’t expect because of its recent earning guidance), our calculations tells us they will manage to get 19% IROE for the year 2016. This lower returns are reflecting in its pricing today in the market (though we still consider this business expensive from our calculations of estimate intrinsic value)

We do analyse very closely from where the profits will be realised in the future to help us to estimate the business intrinsic values. IROE is where we start our analysis for it.

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 advise you to take professional advice before going ahead with our views.