Returns and it's importance on Investing in Shares

Returns and it's importance on Investing in Shares 

Introduction

Average nominal GDP growth rate of India was around 12% for the past 5 years. 

(Nominal GDP includes both prices and growth, while real GDP is pure growth. Real GDP  is what nominal GDP would have been if there were no price changes from base year. As a result, nominal GDP is higher than real GDP)

A return on capital in excess of nominal GDP can be considered as a good return from investor perspective. Return on Capital Employed (ROCE) helps an investor understand what is the level of profitability with respect to total capital employed in the business. Return on equity (ROE) and return on assets (ROA) are also important ratios to asses the efficiency of the business with respect to owners fund and assets deployed respectively. The higher these ratios the better. Again these ratios are measure of efficiency of business. We want to invest in companies/shares which are most efficient and thereby will yield investor maximum returns

Investing activity is normally undertaken with objective of capital appreciation. Returns which the underlying business generates has a substantial and direct impact on the share prices of the company. Higher the return a business generates with consistency the better share price appreciation will be reflected. Investing in equity (shares) comes with it's inherent risks. When capital is invested in shares a return which is in excess of risk-free rate has to be generated otherwise there is no rationale of taking the risk.

Formula for calculating Return on Capital Employed (ROCE) : 

Return on Capital Employed (%) = Earnings before Interest & Taxes / Capital Employed

Capital Employed = Total Assets - Current Liabilities

Formula for calculating Return on Asset (ROA) : 

Return on Assets (%) = Profit After Tax / Average Total Assets

Average Total Assets = (Assets at beginning of year + Assets at End of Year) / 2

Important points in respect of Returns : 

• ROCE and ROA are two important return ratios for evaluating investment in shares of a company. Companies with lower ROCE and ROA must be altogether avoided. ROCE must be always greater than weighted average cost of capital employed.

• Return on Capital Employed (ROCE) is a better assessment ratio for returns compared to Return on Equity (ROE) because it is possible to inflate Return on Equity (ROE) by taking high levels of debt which may not be sustainable for business

• By using ROCE, investor can compare whether company is employing it's capital efficiently in comparison to peers in the sector as well as on standalone basis

• News and media normally talks about profit and turnover figures. However for an astute investor it is important to verify how much capital has been employed to generate the amount of profits. Eg. Business A and Business B both in same sector have generated profits of 40 crore for the year. But Business A has employed 250 crore of capital and Business B has employed 175 crore of Capital. With this data we can easily determine that investor will be willing to invest in Business B because it is more effective

• Return on asset (ROA) is higher for companies with asset-light business model rather than capital intensive businesses. Eg. Sectors like Steel, telecom, defense etc. have low ROA while consumption companies are likely to have higher ROA