Your Money: How to use excess returns as an investment filter

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May 17, 2021 6:30 AM

A firm with excess return for its debt and equity investors is efficient in managing its explicit and implicit profitability

Excess Return of DS is 24.99% (= ROE of 40% less COE of 15.01%).Excess Return of DS is 24.99% (= ROE of 40% less COE of 15.01%).

When valuing firms, young investors find it difficult to identify the criteria for selecting the best performing firms. Let us discuss the use of excess returns as an investment filter.

Hypothetical illustration
Let us see the latest financial data (in Rs crore) for Dinesh Samin Ltd (DS): Earnings Before Interest & Tax (EBIT) 3,500; Profit Before Tax( PBT) 3,000; Profit After Tax (PAT) 2,000; Effective Tax Rate 33% ; Shareholders funds 5,000 ; Total assets 10,000; Current liabilities 2,000; Risk-free rate 6.85%; Market Risk Premium 6.80%; Equity Beta 1.20 times; Book value of Debt 3000; Market capitalisation 50,000.

Excess return for equity shareholders
It is computed as excess of Return on Equity ( ROE) over Cost of Equity (COE). ROE is calculated by dividing the PAT by the shareholders’ funds. For DS, it is 40% (PAT of Rs 2,000 crore divided by shareholders funds of Rs 5,000 crore *100).

COE is the minimum rate of return expected by the equity investors from a firm. It could be computed by the Capital Asset Pricing Model (CAPM) as the sum of risk-free rate and the product of equity beta and market risk premium of a firm. For DS, it is 15.01% (Risk free rate of 6.85% for India plus product of equity beta of the firm of 1.20 and market risk premium of 6.80% for India).

Excess Return of DS is 24.99% (= ROE of 40% less COE of 15.01%). So DS is earning return of Rs 24.99 after covering the cost of funds for its equity shareholders. A firm with excess return for its equity shareholders is efficient in managing its explicit and implicit profitability and therefore a recommended one for investment.

Excess return for the firm
It is computed as excess of Return on Capital ( ROC) over Cost of Capital (COC) of a firm. ROC is calculated by dividing the after-tax EBIT by the invested capital of a firm. For DS, it is 29.31%. Invested capital is the excess of total assets over current liabilities and for DS it is Rs 8,000 crore.

COC is the minimum rate of return expected by both the debt and equity investors of a firm. It is the weighted average of COE and after-tax cost of debt of a firm with market value weights for debt and equity. COE for DS is 15.01%. Pre-tax cost of debt is 16.67% (interest of Rs 500 crore divided by book value of debt of Rs 3,000 crore).

The difference between EBIT and PBT is assumed to be interest expenses here and it is assumed that there is no other income earned by the firm. After-tax COD for DS is 11.17 %. Equity / Value is 0.94 (Rs 50,000 crore/Rs 53,000 crore). Therefore COC is 14.78% (15.01 *0.94 + 11.17*0.06).
Excess return of DS for both debt and equity investors is 14.53% (ROC of 29.31% less COC of 14.78%). So DS is earning return of Rs 14.53 after covering the cost of funds for its debt and equity investors. A firm with excess return is efficient in managing its explicit and implicit profitability.

It would be better to decide based on the average excess return for the past 4-5 years instead of just one year or period.

The writer is associate professor of Finance at XLRI – Xavier School of Management, Jamshedpur

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