Economics of a business

In this post, we discuss 5 effective ways to evaluate the inherent economics of a business.

Indian stock universe is large and over 7,000 companies are listed on Indian stock exchanges (NSE and BSE). That's a huge number. However, a business needs to have compelling economics to qualify as 'investible'. Below wisdom from Warren Buffet underpins the importance of good economics.

"When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact"

Inherent economics are important and below are simple yet effective parameters to evaluate the same. Let's dive in!

Gross margins (Higher the better)

Gross margins are often less emphasized while evaluating a business. We are generally more obsessed with EBITDA and EBIT margins. However, gross margins provide primary evidence of 'value addition' by the business. Higher gross margins are generated by businesses with 1) Better pricing power 2) Higher value add through the manufacturing process 3) Effective raw material sourcing and access to low-cost inputs. Furthermore, businesses with higher gross margins usually have higher operating and net margins as well. Operating margins can be improved through cost reduction and efficiency measures. However, lower gross margins are difficult to fix as it normally means that the value added by the business is not that high.

Cost structure (Variable costs are preferred)

Cost structure (i.e. ratio of fixed costs to variable costs) provides an important clue with regards to the nature of business. Higher fixed costs indicate that a business is operationally intensive and needs to incur certain expenses just to maintain its operations. Imagine a manufacturing setup. Factory rent, wages, repair and maintenance of equipment, depreciation on plant and machinery, etc. are some of the fixed overheads that are incurred by this business regardless of any sales. In a dull demand environment, such businesses suffer in terms of profitability. Hence, businesses with the majority of costs being variable or semi-variable (i.e. linked with the sales volume), are relatively stable in terms of profitability and resilient to demand shocks. How to judge whether a business has a benign cost structure? Check for consistency in margins over the years.

Capital expenditure (Lower the better)

Capital expenditure (Capex) is the investment required in fixed assets (property, plant, and machinery) to sustain and grow operations. In a sense, Capex is the fuel for growth and some businesses require a lot of it. Manufacturing businesses usually require incremental investments for capacity expansion. However, some businesses such as power transmission, telecom, steel, textile, etc. require consistently high investment in physical assets to sustain growth. This requirement for higher Capex also stems from the rapid rate of change in technology. The best example is telecom where a change in communication technology (3G,4G,5G, etc.) requires substantial investment in revamping the tower infrastructure. Compare this with IT or FMCG where growth is supported by intangible factors such as brands, product development capabilities, technical know-how, superior distribution, etc. Businesses having lower Capex requirements for growth usually have higher FCFF (Free cash flow to the firm) generation.

Working capital requirement (Lower the better)

Working capital means net investment in current assets (Current Assets - Current Liabilities). Some businesses require to maintain high levels of inventory, take longer to realize collections from debtors or get lesser credit from suppliers. In other words, their cash collection cycle (Stock days + Debtor days - Creditor days) is longer. In such cases, funds get tied up in working capital and the business requires borrowed capital to support the liquidity which entails interest costs. Some businesses inherently require more working capital. For example, businesses that deal with governments have higher receivable days. Less working capital intensive businesses are more likely to generate higher operating cash flow. This is best reflected in the operating profits to CFO (Cash flow from operations) conversion ratio.

Asset efficiency (Higher the better)

Asset turnover is defined as a ratio of sales to average assets. A version of this is the 'Net Fixed Asset Turnover ratio' which simply means the sales generated per rupee of fixed assets invested in the business. To put it simply, it's a measure of asset efficiency. Businesses with high asset turnover (say more than 1.5) are usually asset-light. B2C businesses such as FMCG, Consumer Durable, and Retail fall into this category. Capital intensive businesses such as Pharma, Textiles, Capital Goods, and Realty have comparatively lower asset turns. Higher asset efficiency is usually coupled with higher ROA (Returns on Assets).

In the end, it all boils down to return on capital (ROE and ROCE). The above parameters in some way contribute to either the numerator or denominator in the ROCE ratio (EBIT/Capital employed). We can safely conclude that if the business has good inherent economics, it will reflect through high returns on capital generated by it. The reverse is also true. However, these parameters are subjective and depend a lot on the sector in which a business operates. Nevertheless, they give clues as to why a business generates superior returns on capital.