Asset Allocation: Value Creator Or Destroyer?

In the wake of the recent instance of Mahindra and Mahindra acquiring a 3.53 per cent stake in RBL Bank Limited that led to a drop in the automobile major’s share price, Shashikant takes a look at the role of asset allocation and how a company’s CFO can drive decisions that can either benefit or harm shareholders’ interests 

On July 27, 2023, the shares of Mahindra and Mahindra experienced a decline of up to 6.9 per cent during intra-day trading. This drop came following the announcement that the company had acquired a 3.53 per cent stake in a private bank – RBL Bank Ltd. – with a potential plan to increase its stake to 9.9 per cent in the future. While on the surface this treasury operation seemed unproblematic involving Mahindra and Mahindra purchasing shares using cash from its reserves, the market response, however, was unfavourable. The acquisition of this 3.5 per cent stake was met with concern from the market regarding its capital allocation strategy.  [EasyDNNnews:PaidContentStart]

Additionally, this move has raised uncertainties about the company’s intention to further invest in the bank, which could lead to short-term unpredictability concerning its capital allocation decisions. One contributing factor to the share price decline was the belief among several analysts that this acquisition might not prove advantageous for the conglomerate. This is given that Mahindra and Mahindra’ primary business lies in the automobile sector and the investment in the bank could be viewed as “non-synergetic” with its core focus on automobile manufacturing. 

This is not the first or last time that we have come across such a decision by the management of the company where they have reallocated the capital to an unrelated business. In fact, researchers, as represented in the image alongside, found an optimal degree of reallocation. But they also discovered that only less than 1 per cent was above that threshold. In other words, the vast majority of companies could improve their financial performance by increasing their reallocation. Let us, however, understand the importance of capital allocation and if it plays any role at all in the performance of companies and their share price.

Role of CFO in Asset Allocation

The primary mission of the top corporate management is to generate long-term value for their shareholders. This entails harnessing diverse resources, encompassing both capital and labour, and enhancing their worth beyond their initial outlay over time. Within this value creation framework, the strategic allocation of capital, delineating how a company secures and employs its funds, occupies a pivotal role. Skilful capital allocation yields sustained value for all stakeholders. However, the central focus of the Chief Financial Officer (CFO) should be directed towards enhancing the long-term value per share. 

The imperative to foster value creation stems from at least two pivotal factors. First, the competitive landscape comes into play. A company that mishandles its resources risks being outperformed in the market by more adeptly managed competitors. Secondly, the concept of opportunity cost of capital demands attention. Corporations must explicitly acknowledge that every unit of capital carries an opportunity cost – the potential return achievable from the next optimal alternative. Capital that falls short of earning its cost of capital over extended periods erodes value and endangers a company’s prospects for triumph. The skilful allocation of capital stands as a pivotal duty of the CFO, necessitating a mastery to excel in this domain.
 

Understanding Asset Allocation 

How does one measure better asset allocation? How can we assess a company’s effectiveness in capital allocation? An influential financial gauge that promptly reveals a company’s track record in capital allocation is the return on capital employed (ROCE). ROCE quantifies the profit generated by a company in relation to its employed capital. The numerator of the ROCE equation is the net operating profit after tax (NOPAT), a figure also employed in calculating free cash flow. NOPAT signifies a business’ cash earnings, excluding the impact of interest expenses from debt and interest income from excess cash. The capital invested represents the net assets a company requires to yield NOPAT, or equivalently, the amalgamation of debt and equity utilised to fund these assets. 

Yearly investments determine the fluctuations in invested capital. This connection unveils the interplay between free cash flow and ROCE. Investment is subtracted from NOPAT to derive free cash flow, while NOPAT forms the numerator of ROCE and invested capital signifies accumulated investment. A more crude way of measuring ROCE is using EBIT (earnings before interest and tax) as a numerator and the company’s capital employed, which is total assets less the current liabilities as a denominator. A ROCE surpassing the cost of capital indicates that a company is generating value. To illustrate, consider a scenario where a company achieves NOPAT of ₹ 200 with an invested capital of ₹ 1,000, while facing a cost of capital of 14 per cent. 

In this case, the company’s ROCE of 20 per cent i.e. ₹ 200 | ₹ 1,000 surpasses the 14 per cent cost of capital, indicating strong value creation. Conversely, a business with the same invested capital that yields ₹ 100 would display ROCE of 10 per cent (₹ 100 | ₹ 1,000), falling below the cost of capital. A company that is able to churn out a greater profit from its existing capital base is rewarded disproportionately by the market. In fact, a 2011 study by PwC of listed BSE 100 companies found that “on an average, companies that deliver a better return on capital employed experience higher valuation.” The management’s goal should be to create value by making investments that earn a return in excess of the opportunity cost of capital. ROCE is one way to measure whether a company has achieved this goal.
 

Evidence of Asset Allocation and Share Price Performance 

To delve into the significance of asset allocation as measured by ROCE, we conducted a comprehensive study focusing on the constituents of BSE 500 companies. Data spanning the past 13 years up to FY23 was analysed with exclusion criteria applied to the banking and finance sector as well as sectors with fewer than five companies. The graph illustrates the evolution of average ROCE for various sectors over the period of FY10 to FY23. Notably, the IT sector’s ROCE experienced an upward trend, ascending from 20.73 per cent in FY20 to approximately 31 per cent in FY23. Concurrently, the Nifty IT index surged 70.9 per cent during this timeframe.

Comparatively, the Nifty Pharma index witnessed a more modest rise of 34.67 per cent. Although the pharmaceutical sector’s ROCE initially improved from 18.71 per cent in FY20 to 23.74 per cent in FY21, it subsequently declined to 17.42 per cent in FY22 before recovering to 19.73 per cent in FY23. The correlation between ROCE and the respective index returns is evident through the alignment of movement in ROCE with changes in the indices’ returns. To gain insights into the relationship between ROCE and stock returns, we conducted a regression analysis of annual stock returns against their corresponding ROCE figures for each year. Outliers were excluded from both ROCE and annual returns prior to the regression analysis. 

The graph alongside portrays the relationship between ROCE and annual returns. A conspicuous positive correlation is observed between higher ROCE values and improved stock price returns. This relationship holds substantial statistical significance, evident from the virtually zero p-value.
 

Higher ROCE, Higher Valuation: The Market Reaction 

Taking our analysis a step further, we sought to examine whether a higher ROCE translates into favourable recognition from market participants. As expected, companies with elevated ROCE tend to receive more favourable valuations compared to those with lower ROCE figures. Our research indicates that on an average companies that achieve superior ROCE levels also enjoy higher valuations, as evidenced by both price-to-book (PB) and price-to-earnings (PE) multiples at which their shares are traded. Essentially, this implies that the market places a premium on firms capable of compounding capital at elevated rates of return. 

Such companies are valued more highly in comparison to their peers that generate returns at relatively lower rates. This phenomenon leads to a reduced cost of capital and minimised equity dilution for future fundraising endeavours for those companies that excel in capital management. The subsequent graphs vividly illustrate the correlation between ROCE and distinct valuation metrics. In the context of the PB multiple, nearly 57 per cent of its variability is influenced by ROCE. Similarly, in the case of the PE ratio, approximately 10 per cent of the variability is attributed to ROCE.

Going Ahead

As of the conclusion of FY23, Mahindra and Mahindra has ROCE of 13.6 per cent while RBL Bank reports ROCE of 5.7 per cent. At first glance, the recent transaction seems inclined to potentially diminish Mahindra and Mahindra’s ROCE, thereby dampening market enthusiasm and resulting in a decline in its share price. However, if this transaction extends beyond a mere treasury operation and incorporates a strategic rationale, there exists the possibility of witnessing resurgence in the company’s share price. The precision of capital allocation decisions is paramount for a CFO as it serves as the cornerstone of a company’s sustained growth and heightened returns for shareholders. 

Ineffectual capital allocation can give rise to sluggish growth, diminishing profits, and a reduced capacity for value creation. While an ideal scenario envisions capital allocation choices being impartial and grounded in empirical data, the reality is that such decisions are influenced by human judgment. These judgments can harbour inherent biases, such as a tendency to favour investments in preferred business lines, overestimating potential benefits or success probabilities, or prioritising short-term gains over long-term value augmentation. Enhanced capital allocation practices hold the potential to drive compelling returns for shareholders, facilitating capital accessibility and presenting opportunities to establish a competitive edge.
 

Methodology 

To compile the CFO rankings, DSIJ examined the performances of companies listed on the BSE across market capitalisation and sectors. The financial performance was examined over 12 months ended March, 2023 or December 2022 as the case may be. DSIJ evaluated the financial on twelve financial metrics. Equal weightage was given to the increase in market capitalisation (includes share price increase and equity issued), followed by growth in sales, operating profit and net profit. Return ratios were also considered for the ranking purpose as well. The segregation of companies into Large-Caps, Mid-Caps and Small-Caps was made based on DSIJ's definition of market capitalisation categorisation. For the purpose of ranking, the best performing CFOs in ten major sectors and different caps were considered, including one special category for women CFOs. 
 

Click here to download list of CFO awards 2023 

[EasyDNNnews:PaidContentEnd] [EasyDNNnews:UnPaidContentStart]

[EasyDNNnews:UnPaidContentEnd]