Being profitable is hardly the evidence of a good business


Profit or Earnings Per Share (‘EPS’) is just an illusion. However, it is still considered a holy grail and sought-after number, tracked by most analysts. I have often wondered WhyProfit/Loss emanating from Profit & Loss Statement or EPS does NOT take 3 elements into consideration:

  • Principal Repayment of loan / debt, if any (gets featured in Cash Flow from Financing)
  • Capital expenditure required for long-term functioning and growth of the business
  • Working capital required for daily operations of the business

Looking at ITC and Tata Motors resulted in some interesting findings:

ITC during the last 17 years has had cumulative profit of INR 91,289 crores, Tata Motors during the same corresponding period has had cumulative profit of INR 93,314 crores. Considering that each of these companies have had approximately similar amount of profit during the period,

One may tend to believe that with equivalent profitability, both the companies would be valued similarly. Alas, this is not usually true.

ITC’s market capitalization rose by INR 300,000 crores during the 17-year period as compared to a mere INR 100,000 crores increase for Tata Motors, 200% more than a company having equal earnings for the same period.

While ITC invested close to INR 48,000 crores in the business over the last 17 years, Tata Motors during the same period invested close to INR 180,000 crores. So technically, with every INR 1 rupee of capital employed by ITC, it was able to generate profit of INR 1.90, whereas for every INR 1 rupee of capital employed by Tata Motors, it generated profit of merely INR 0.50.

Now, comes the interesting part, ITC has not had any external capital requirement during this period, i.e. the entire investment was funded by the cash flows being generated out of the business over the course of time.

Tata Motors, on the other hand has had dependency on external capital, to the tune of approximately INR 86,000 crores during the corresponding period. (Increase in Gross Debt during the period) Out of INR 180,000 crores of capital being employed in the business during the said period, 48% (INR 86,000 crores) had been funded by debt. This clearly demonstrates that while the company made profits, capital and working capital expenditure was higher, hence requirement of external capital.

Leveraging one’s business may generate profit in the short-run, however, without adequate cash flows, the business would ultimately collapse.

ITC generated Free Cash Flow of approx. INR 69,000 crores during the period as compared to Tata Motors which incurred negative FCF (INR 27,500) crores during the same corresponding period; i.e. capital expenditure and working capital needs were more than the cash flow from operations.

Next time, somebody rattles about profit or EPS, please do not permit that number to warp your judgement.

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

 

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