Your Money: Is your target firm on the value creation track?

March 22, 2021 1:30 AM

Look out for increasing trend in revenue growth and EBIT margin and decreasing trend in expenses, reinvestment rates and levered beta

Cost of goods sold (CGS), selling general and administration, depreciation and amortization, interest and tax are the major heads to be analysed to assess the expenses management efficiency of a firm.Cost of goods sold (CGS), selling general and administration, depreciation and amortization, interest and tax are the major heads to be analysed to assess the expenses management efficiency of a firm.

By N Sivasankaran

Young investors need to identify the indicators of value for their investment candidates and compare them on both time series (historical) and cross sectional (inter firm) basis on the identified value measures to ensure the accomplishment of the targeted return on investment. Here is a checklist for value creation by investors.

Growth rate in revenues
This is the primary indicator of the value enhancement for the equity shareholders of a firm. One can compute the CAGR in revenue of the target firm and gauge the trend of the movement of its revenue on historical and intra firm basis. If the target firm has CAGR of 12% in revenue while the industry average is 8%, then certainly the target firm is on the value creation track.

Expenses management
Cost of goods sold (CGS), selling general and administration, depreciation and amortization, interest and tax are the major heads to be analysed to assess the expenses management efficiency of a firm. If a firm’s expenses as a per cent of revenue comes down over 3-5 years and its expenses as a percentage of revenues are the lowest compared to its peers, then the firm is efficient in expenses management.

Operating income
Operating income, otherwise known as operating profit, reveals the true profitability of a firm in its core activities. If a firm produces an increasing trend in its EBIT margin over the past 3-5 years, then it is attractive for investment by the equity shareholders.

If a firm’s EBIT margin is higher than the industry average, then its attractiveness to equity investors increases further. It would be better to consider the post-tax EBIT margin in the analysis.

Reinvestment amount
If the delta reinvestment adjusted for depreciation and amortisation of the current year decreases compared to that of the previous year then the firm is generating cash flows for its equity shareholders, else it is blocking the cash flows of the equity investors. Hence, lower the reinvestment requirements of a firm, better is its value.

Levered beta
Also known as Equity Beta, it reflects the cumulative risks of a firm caused from its business risk, operating leverage risk and its financial leverage risk. A firm with lower concentration on customers/suppliers/marketing partners and a lower degree of operating and financial leverage is a favourable investment shortlist.

A good firm is one which shows an increasing trend in growth in revenues, decreasing trend in expenses, increasing trend in EBIT margin, decreasing trend in reinvestment rates and levered beta.

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

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