Motilal Oswal has been coming out with a wealth creation study on an annual basis over the last two decades. Over the years, each of its studies has given investors lessons to help them find wealth creating companies. This time it stresses on looking at economic profit rather than accounting profit, along with other qualitative-based indicators, in order to achieve ‘hockey stick returns’.

Hockey stick returns primarily refer to sharp and sustained rise in the price of a particular stock, which can lead to a hockey-stick formation of the price chart, ultimately creating wealth for investors. Here are some takeaways from the study.

Economic profits over accounting profit

Typically, accounting profit i.e. net profit, is the most widely used tool for financial analysis of a company. However, the study highlights that while the accounting profit takes into account all the explicit costs, including cost of debt (interest cost) in determining  company’s profits, it doesn’t incorporate implicit cost of invested equity capital (cost of equity). Economic profit can be calculated by mutliplying Net worth with spread between return on equity and cost of equity.

While there are different formulae and methods to calculate cost of equity, in simple terms, cost of equity is the return required by an investor while making equity investment in a company. For simplicity, Motilal Oswal has considered cost of equity as 10 per cent, which is equivalent to the long-period return on Indian equity markets.

Let’s take Indian Oil, for instance. In FY23, the company has been able to generate net profit of around ₹9,800 crore and thereby has delivered ROE of around 7 per cent. Though the company has generated accounting profit, due to lower ROE, it had an economic loss of around ₹4,200 crore. Likewise, investors can look for companies that have generated economic profits and have the ability to grow it at a reasonable pace.

The TEMP framework   

The study has come up with a framework called TEMP (trends, endowment, moves and price) to help investors find companies with high economic profits at reasonable price and thereby generate hockey stick returns. One, trends are primarily the factors external to a company — such as shifts in broader economy and sector. Favourable trends can help companies generate economic profits.

For instance, the stock of Astral delivered returns at around 45 per cent CAGR during 2013-2023, which was driven by favourable trends in the industry — such as demand shift from unorganised to organised sector owing to GST implementation, government initiatives to improve penetration of tap water, strong uptick in real estate activity and value migration from metal pipes to plastic pipes.

Two, external trends can be favorable to a company only if it is internally strong enough to ride the favourable trends. The internal factors are referred to as endowment here. Let’s take financial services firm Bajaj Finance. . There have been favourable developments in the financial services space during 2013-23 such as steady systemic credit growth of 10 per cent, boom in consumer durables space and strong adoption of digital payments. While these favorable trends help, it was Bajaj Finance’s internal strengths (endowments) such as strong parentage, dealer network (578 dealers and 2,130 sub-dealers) in 75 cities and sustained customer relationships that helped it take advantage of the external factors and generate 58 per cent CAGR returns in the last 10 years.

Three, a company also needs to take strategic initiatives during its course of business to leverage its trends and endowments in order to drive economic profits growth — referred to as moves here in the study. It helped the stock of integrated agri chemicals solution company PI Industries generate CAGR returns of around 37 per cent in last 10 years. Moves such as its consistent investments in R&D and diversification into pharma and specialty chemicals space have helped the company leverage its strengths; rising application of pesticides, increased outsourcing by global players, PI’s robust manufacturing infrastructure and cost-competitiveness have been some of the favourable trends and endowments for the company.

Studying the trends, endowments and moves can help one find fundamentally strong companies that have been able to generate economic profits. However, in order to find attractive investment opportunities, economic profits need to be coupled with an appropriate price (valuation) at which stock needs to be bought. Of Nifty 500 companies, 54 companies have delivered hockey stick returns in the last 10 years. Here, the study has given an indicative P/E number of less than 20 times, which has been the case of 70 per cent of the companies generating hockey stick returns. Ultimately, increase in economic profits along with P/E expansion can result in such wealth creation

Investor takeaways

After applying the TEMP framework, Motilal Oswal has arrived at a list of 16 companies that have generated highest CAGR returns in the last 10 years (at least 38 per cent CAGR returns). These are the companies that have been able to grow their economic profits more than 15 per cent annually and have seen P/E expansion of at least 2 times. Investors can use the TEMP framework in order to figure out companies that have sector tailwinds in place, internal strength, ability to take strategic initiatives with changing business environment and are available at attractive valuation, which provides scope of P/E expansion.

Further, accounting earnings apart, investors can apply economic profits as a valuation driver. For instance, one can value companies through price to economic profits and price to economic profits growth (similar to PEG ratio).