What binds Dixon and DMart?

Generating returns in a 3% margin business

Two darlings of the stock exchange – Dixon and DMart

Both Dixon and DMart has been in the ‘D-Company’ of the Indian Stock Exchange. While the former trades at a PE multiple of close to 90x, the latter trades at 130x.

The irony here is that both these companies have single digit operating margins and have close to triple digit Price to Earnings ratio. So, what binds them together?

Let’s start with Dixon. Dixon acts as a contract manufacturer for consumer durables and is the only listed player when it comes to this industry. Banking on the rising urbanization and the need for the human population to continuously improve their efficiency in life, Dixon continued to grow on increased orders for consumer durables.

On the other hand, DMart currently is the bellwether of the Indian retail industry. Backed by ace Indian investor Mr. Damani as its promoter, DMart has swiftly moved from 2 stores in Mumbai to 214 stores in FY 2019-20 in a span of 20 years.

Both Dixon and Dmart, despite having low margins have great ROEs. How is that possible?

Allow us to introduce you to the concept of DuPont Analysis. The idea behind DuPont analysis is to break down ROE into three parts – Margin, Asset Turnover and Financial Leverage. This basically means that any ROE is driven by these three factors.

For a low margin business, the asset turnover needs to be high i.e. the sales generated by the firm should be significantly higher compared to its average assets. This helps in improving the ROE multiplier and thus even on a lower margin a firm can have a higher ROE.

The final component of the ROE is financial leverage. Financial leverage is like a double-edge sword. While on the one end, it does improve the ROE by expanding the multiplier effect (taking more debt reduces the equity base and in effect improve the financial leverage – often referred to as ‘gearing’), it can cause serious issues w.r.t. debt serviceability and liquidity of the company, especially in a low margin business.

Both Dixon and DMart have low financial leverage and high asset turnover ratios. This makes both these companies stand out when it comes to their Return on Equity thereby making them companies that are commanding higher PE multiples.

There’s always one thing to always look out for while investing in companies with high PE multiples - adequate Margin Of Safety. This basically implies whether as an investor you are comfortable accommodating for any adverse events. The earnings may not differ materially in a short span of time but the perception of a stock can change overnight leading to PE de-rating.

About the author: This post is written by Saket Mehrotra with relevant edits from our editorial team. Saket is a CA, CS by profession.