ASIAN JOURNAL OF MANAGEMENT RESEARCH Online Open Access publishing platform for Management Research

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1 ASIAN JOURNAL OF MANAGEMENT RESEARCH Online Open Access publishing platform for Management Research Copyright 2010 All rights reserved Integrated Publishing association Review Article ISSN A study on the correlation between market capitalisation and economic value added as measures of profitability Associate Professor Finance, MITSOT, Pune maya@mitsot.com ABSTRACT There are several measures of profitability for a company including return on investment (ROI), Earnings per share (EPS), Return on Equity (ROE) and many others. However none of these takes into consideration the cost of capital. Thus a new measure namely Economic Value added was introduced by Stern Stewart. This paper tries to find if there is any correlation between market capitalization and economic value added of select companies listed on the BSE.The reason for choosing these two measures is that the former is purely based on the psychology of the investors and cannot be controlled by the firm directly. However the latter (EVA) is calculated based on the book values of the company and also considers the return required by investors (cost of capital). Keywords: Profitability, Cost of capital, Market Capitalisation, Correlation 1. Introduction There is a wide choice of financial institutions that provide investors several options by which they can save and at the same time ensure that their money grows. We can broadly classify these as those that provide a secure income such as banks, pensions funds and insurance companies and secondly those where the investor takes considerable risk such as the capital markets and mutual funds. An investor considers factors like the rate of interest, potential for capital growth and convenience such as liquidity considerations, simplicity of operations and tax benefits. There are several indicators of financial performance which are available to an investor. Some of the traditional indicators are Market Capitalisation, Return on investment (ROI), Earnings per Share etc.market capitalization is the product of market price per share and the number of shares outstanding. It is a very popular measure of investor confidence and wealth creation. It is a measure of the perceived earnings of the firm and is external to the company s books of account. As such it does not take into consideration the impact of costs such as taxes and interest (non-operating) or operating expenses. Earnings per share (EPS) are measured by dividing profits after tax by the number of shares outstanding. It reflects the changes in costs and sales but does not consider the market sentiments of investors. ASIAN JOURNAL OF MANAGEMENT RESEARCH 138

2 Return on investment (ROI) is given by profits after tax divided by the total assets of the firm, and is treated as a standard measure of the firm s profitability. However as we can see none of these measures takes into consideration the intrinsic cost or the cost of capital to the firm. This is more applicable to equity capital as there is no legal liability on the firm to pay any dividend. As such how can one know what the true profit of the firm is unless the cost of capital is considered? It was to overcome this problem that the concept of Economic Value Added (EVA) was introduced by Stern Stewart.EVA is the difference between NOPAT (Net operating profit after tax) and the Cost of Capital. 2. Materials and Method Scope of the Present Study This study aims to find the correlation if any between two of the above mentioned measures of profitability namely Market Capitalization and Economic Value Added for select companies listed on BSE Sensex.The reason for taking these two measures is that the former is a measure given by investor perception while the latter is given as per the books and at the same time taking into consideration the cost of capital. Hence it is aimed at finding out whether both these measures give the same results or not. A positive correlation will indicate that both the measures give the same result about the company s profitability while a negative correlation indicates that the results indicated by the two measures are different. As such in the latter case a test of significance is done to find the reliability of the result. Objectives of the Study 1. To find out the correlation if any between Market Capitalization and Economic Value Added of the companies selected. 2. To find out the sector wise correlation between Market Capitalization and Economic Value Added for the sectors considered. 3. To find out whether the companies selected for study are wealth creators or not based on their EVA values. 4. To do a test of significance wherever a negative correlation is seen. Hypotheses (For Correlation Values) Null Hypothesis H0: There is no correlation between market capitalization and economic value added. Alternate Hypothesis H1: There is a correlation between market capitalization and economic value added. Hypothesis (For Test of Significance) Null Hypothesis H0: The results of correlation are not significant. Alternate Hypothesis H1: The results of correlation are significant. Research Design ASIAN JOURNAL OF MANAGEMENT RESEARCH 139

3 Period of Study The study covers a period of five years from to Sample Size Seventeen companies listed on the BSE-SENSEX are included in the study. These companies are categorized into four sectors namely Automobile sector, Pharmaceutical Sector, FMCG Sector and Oil and Natural Gas Sector. The basis of this selection is to get a representation of totally unrelated sectors as this will increase the validity of the results. Sample Profile The companies selected are public limited companies for which data is available for the years considered. Collection of Data The source of data for this study is secondary. The data is collected from the annual reports of the company and for this the Profit and Loss Account statements and Balance Sheet have been considered for the said period. Methodology for Analysis EVA=Net Operating Profit after Taxes-Cost of Capital Employed Where, Cost of Capital Employed=Weighted average cost of capital (WACC) x capital employed WACC= (Kd x wd) + (Ke x we) Kd=cost of debt given by Interest divided by total debt Wd=proportion of debt in total capital Ke=cost of equity given by dividend paid during the year divided by opening price (Di/P0) We=proportion of equity in total capital. Capital employed=total capital current liabilities Market Capitalisation(MC)=Market Price Per Share x No. of shares Here Market price is the 52 week average for each year under study Coefficient of Correlation Karl Pearson s measure of correlation has been used in this study. It is given by the formula r = (X-µX) (Y-µY) σx σy ASIAN JOURNAL OF MANAGEMENT RESEARCH 140

4 where r is the correlation coefficient, X is the series of EVA of companies and Y is the series of Market capitalization values and µx and µy are the average values of X and Y respectively. σx and σ Y are the standard deviation values of X and Y. The r value will lie between +/- 1.A positive value indicates that the two variables are moving in the same direction and a negative value indicates that they are moving in opposite directions Wealth Creation A positive EVA indicates that the company is able to make profit even after covering its cost of capital. Hence it is treated as a wealth creator. Test of Significance A t-test has been done in those sectors where the correlation value is negative. This is a onetailed test used when the sample size is less than thirty. The formula used is T= Where r is the correlation coefficient for the sample, n is the sample size that is the number of companies included in the study. The calculated value is then compared with the table value at.05 level of significance. If the calculated value is less than the table value we accept the null hypothesis. Analysis and Interprtation of Data Tables Showing Correlation between Eva and Market Capitalisation I Automobile Sector Table I 1: Bajaj Auto * Year crore) 1, , crore) R 0.20 for the above company in the automobile sector. The value of EVA is also positive indicating that the company is a wealth creator. *Data was unavailable for the year ; hence the findings are only for four years. ASIAN JOURNAL OF MANAGEMENT RESEARCH 141

5 Table I 2: Hero Honda Motors crore) crore) R 0.89 for the above company in the automobile sector. The value of EVA is also positive indicating that the company is a wealth creator. Table I 3: Kinetic Motor Company crore) crore) R 0.44 for the above company in the automobile sector. The value of EVA is also positive indicating that the company is a wealth creator. Table I 4: TVS Motor Company crore) crore) R 0.58 for the above company in the automobile sector. The value of EVA is also positive indicating that the company is a wealth creator. Sector Correlation The average correlation value for all companies in the sector is As this is a positive value indicating that the two measures give the same result, there is no need for further testing. II. Pharmaceutical Sector ASIAN JOURNAL OF MANAGEMENT RESEARCH 142

6 Table II 1: Cipla Ltd. crore) crore) R 0.80 for the above company in the pharma sector. The value of EVA is also positive indicating that the company is a wealth creator. Table II 2: Lupin Pharma crore) crore) R 0.17 for the above company in the pharma sector. The value of EVA is also positive indicating that the company is a wealth creator. Table II 3: Sun Pharma crore) crore) R 0.49 for the above company in the pharma sector. The value of EVA is also positive indicating that the company is a wealth creator. Table II 4: Ranbaxy Laboratories crore) crore) R ASIAN JOURNAL OF MANAGEMENT RESEARCH 143

7 The analysis shows that there is a negative correlation between Market Capitalization and EVA for the above company in the pharma sector. The average value of EVA is also negative indicating that the company is not a wealth creator. Sector Correlation The average correlation value for the sector is As this is a negative value indicating that the two measures do not give the same result, there is a need for further testing. III. FMCG Sector Table III 1: Dabur India crore) crore) R 0.57 for the above company in the FMCG sector. The value of EVA is also positive indicating that the company is a wealth creator. Table III 2: Marico Industries crore) crore) R 0.62 for the above company in the FMCG sector. The value of EVA is also positive indicating that the company is a wealth creator Table III 3: Britannia Industries crore) crore) R 0.46 ASIAN JOURNAL OF MANAGEMENT RESEARCH 144

8 for the above company in the FMCG sector. The value of EVA is also positive indicating that the company is a wealth creator. Table III 4: HUL * crore) , NA crore) NA R 0.47 for the above company in the FMCG sector. The value of EVA is also positive indicating that the company is a wealth creator. * Data not available for Sector Correlation The average correlation value for the sector is 0.92.As this is a positive value indicating that the two measures give the same result, there is no need for further testing. IV. Oil and Natural Gas Sector Table IV 1: IOC crore) 4, , , , crore) R 0.80 for the above company in the Oil and Natural Gas sector. The value of EVA is also positive indicating that the company is a wealth creator. Table IV 2: HPCL crore) crore) R 0.41 ASIAN JOURNAL OF MANAGEMENT RESEARCH 145

9 for the above company in the Oil and Natural Gas sector. The value of EVA is also positive indicating that the company is a wealth creator. Table IV 3: ONGC crore) , , , crore) R 0.09 for the above company in the Oil and Natural Gas sector. The value of EVA is also positive indicating that the company is a wealth creator. Table IV 4: BPCL crore) crore) R The analysis shows that there is a negative correlation between Market Capitalization and EVA for the above company in the Oil and Natural Gas sector. The average value of EVA is however positive indicating that the company is a wealth creator. Table IV 5: GAIL crore) crore) R 0.82 for the above company in the Oil and Natural Gas sector. The value of EVA is also positive indicating that the company is a wealth creator. Sector Correlation The average correlation value for the sector is As this is a positive value indicating that the two measures give the same result, there is no need for further testing. Result of Hypothesis Test for Correlation ASIAN JOURNAL OF MANAGEMENT RESEARCH 146

10 As there is positive correlation between Market Capitalisation in three sectors,we can accept the alternate hypothesis and reject the null hypothesis. For the Pharmaceutical sector the result is reverse;hence we accept the null hypothesis and reject the alternate hypothesis. Test of Significance This test is required to be done only for the Pharma sector where there is a negative correlation value.the formula used is: T= Where r = 0.728, n = 4 Solving T = The table value is 3.18 at n-1 degrees of freedom and.05 level of significance. As the calculated value is less than the table value we accept the null hypothesis and conclude that the result is not significant and requires further analysis. 4. Conclusion / Suggestions/ Findings After completing the study we find that in three out of the four sectors analyzed there is a positive correlation between Market Capitalization and EVA indicating that the results as given by the two measures are similar. In the Pharmaceutical sector we find that the Correlation value is negative. The negative correlation value in this sector indicates that further analysis needs to be done but that is outside the scope of this paper and hence it is not attempted. 5. References 1. Khan M Y and Jain P K(2011), financial management, Text and Problems, Fourth edition, Concepts and Measurement of Cost of Capital, Tata Mc-Graw Hill Publishing Company Limited, New Delhi 2. Kothari C R,(2004), Research Methodology, Methods and Techniques, Second edition, Research Design,Vishwa Prakashan, New Delhi accessed in April 2011, accessed during July accessed in April 2011, stockinfo/ stockprc.aspx, accessed during July ASIAN JOURNAL OF MANAGEMENT RESEARCH 147

11 5. accessed in April 2011, financials, accessed during July ASIAN JOURNAL OF MANAGEMENT RESEARCH 148