Case 093Long pitches and valuationCore

Dinsha Jewellers grows revenue 20% a year from Rs 5,000 crore at an 8% EBIT margin, but holds 200 days of inventory, so each rupee of new revenue ties up working capital. Is the growth creating value? Compare the ROIC on incremental capital with a 12% cost of capital and a 25% tax rate, measuring inventory days on revenue.

The situation

Dinsha Jewellers runs 140 stores selling gold and diamond jewellery. Revenue is Rs 5,000 crore and growing 20% a year as it opens stores in new cities. Its EBIT margin is 8%. Because every store must display a wide range of designs, it holds inventory equal to about 200 days of revenue, and new stores need the same.

The market loves the growth. Your portfolio manager asks whether that growth earns its keep. Use a 25% tax rate and a 12% cost of capital, measure inventory days on revenue, and assume inventory is the only capital new revenue needs.

Your task

What return does the capital behind each year's growth earn, and is the growth creating value?

Quick check

Roughly what after-tax return does Dinsha earn on the inventory its growth requires?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Growth earns about 11% on the capital it consumes, just under the 12% cost of capital, so faster growth does not help. Each year's Rs 1,000 crore of new revenue needs about Rs 548 crore of inventory and earns Rs 60 crore after tax. Every such year is worth about Rs 48 crore less than it costs. Growth creates value only if inventory falls below about 182 days or the margin rises above about 8.8%.

Step 1Why is revenue growth not the same as value creation?

Think of a sweet shop that can only open a new branch by filling it with a year's stock up front. If each branch earns less on that stock than the owner pays to borrow for it, opening more branches makes the owner poorer, faster. Growth creates value only when the return on the new capital it needs is above the cost of that capital. For Dinsha the new capital is inventory: Rs 1,000 crore of new revenue at 200 days needs about Rs 548 crore of stock.

One year of growth, followed from revenue to the return it earnsExtra revenueRs 1,000 cr20% on Rs 5,000 croreExtra inventoryRs 548 cr200 days of revenueExtra EBIT after taxRs 60 cr8% margin, 25% taxReturn on the new capital against the hurdleIncremental ROIC, 60 / 54810.9%Cost of capital12.0%Each year of growth like this is worth about Rs -48 crore to shareholders
Rs 1,000 crore of new revenue ties up about Rs 548 crore of inventory and earns Rs 60 crore after tax, an incremental ROIC of 10.9% against a 12% cost of capital, so each year of this growth is worth about Rs -48 crore.
The relationship
ROICinc=ΔRev×m×(1−t)ΔRev×days365=m(1−t)days/365=0.08×0.75200/365=10.95%\text{ROIC}_{inc} = \frac{\Delta \text{Rev} \times m \times (1 - t)}{\Delta \text{Rev} \times \frac{\text{days}}{365}} = \frac{m(1-t)}{\text{days}/365} = \frac{0.08 \times 0.75}{200/365} = 10.95\%
mEBIT margin, 8%
ttax rate, 25%
daysinventory held, in days of revenue, 200
What it says in wordsThe return on growth is the after-tax margin divided by the capital each rupee of revenue needs, so it does not depend on how fast Dinsha grows.
Step 2Why does growing faster not rescue it?

Look at the formula: the size of the growth cancels out. Every rupee of new revenue earns the same 10.9% on the capital it ties up, so growing 30% instead of 20% simply does more of a slightly value-destroying thing. Each year of growth invests Rs 548 crore to earn Rs 60 crore forever, worth Rs 500 crore at 12%, so the shareholder is Rs 48 crore worse off per Rs 1,000 crore of new revenue. The reported profits still rise every year, which is why the market can miss it.

Step 3What would have to change for growth to create value?

Either lever will do. Inventory has to fall below about 182.5 days, or the EBIT margin has to rise above about 8.77%. At 150 days the incremental return is 14.6%; at 250 days it falls to 8.8%. This is where the pitch lives: if management's plan to cut design range per store brings inventory to 150 days, the same growth turns from a small drag into real value. Ask also whether suppliers or gold loans fund part of the stock, since only the capital Dinsha itself provides belongs in the denominator.

Return on growth against inventory days: 182.5 days is the line5%10%20%cost of capital 12%182.5 daysDinsha, 200 days: 10.9%growth creates value100150200250300Inventory days on revenue (incremental ROIC on the vertical axis)
At an 8% margin, incremental ROIC falls as inventory days rise and crosses the 12% cost of capital at 182.5 days; Dinsha at 200 days earns 10.9%, just on the wrong side of the line.
Inventory daysCapital per Rs 1,000 cr of growthIncremental ROICVerdict at 12%
12032918.3%creates value
15041114.6%creates value
182.550012.0%breaks even
20054810.9%destroys value
2506858.8%destroys value
Holding the 8% margin, growth creates value below 182.5 days of inventory, breaks even at that level and destroys value above it; at 200 days the return is 10.9%.

Where candidates lose it

The common error is judging growth by the EBIT margin, or by profit growth, both of which look healthy. Neither says anything about the capital the growth consumes, which for a jeweller is the largest number on the balance sheet.

The second is using total ROIC on the existing business rather than the return on incremental capital. Old stores may earn more; the question is what the next rupee of growth earns.

What the interviewer asks next

  • If gold loans fund half the inventory at 6%, what is the return on Dinsha's own capital?
  • Would you rather Dinsha grew 10% at 150 days or 20% at 200 days?
  • How would you check the inventory days from the annual report?

Company names and figures are illustrative.