Why do many top profit-making companies lag in market cap?

A structural shift in the Indian economy, which has gained momentum during the last decade, is the formalization of the economy. Reforms like the GST have hit the informal sector hard. The informal sector, which thrived on tax arbitrage, is finding the going tough in the highly competitive business environment. The inevitable consequence of this transition is the formalization of the economy. The formal sector is steadily gaining market share at the expense of the informal sector.

Consequently, the big ones are getting bigger, with the increasing market and profit share.

In 1991 when India started liberalizing its economy, the top 20 companies accounted for around 14 per cent of India Inc’s net profit. This figure has been steadily rising. It rose to 52 per cent in 2010, and now in 2022, the Top 20 mega-companies account for around 75 per cent of India Inc’s net profit. But it is important to note that many highly profitable companies lag in market cap. This divergence between profits and market cap is significant.

Agencies

What happens when the big get bigger?
The dominance of mega-companies is a global trend, which can be seen in mature market economies like the US and Japan and rising economies like South Korea. These mega companies have access to cheaper capital, superior human resources and the latest cutting-edge technology, which will enable them to grow bigger and stronger.

Also, their huge resources enable them to withstand shocks much better than others. Therefore, most of these highly profitable blue chips should continue to do well.

Why the disconnect between profits and market cap?
It is interesting to note that many companies in the Top 20 in profits do not find a place in the Top 20 in market cap. More importantly, many companies not in Top 20 in profit do find a place in Top 20 in market cap. This is important since market cap largely indicates market’s perception.

A major disconnect between profits and market cap can be seen in the case of the Adani stocks. Gautam Adani has proven expertise in executing large infra projects, but the stratospheric valuations of Adani stocks are a matter of concern.

PSU majors like

and , though highly profitable, are not much fancied because they are perceived by the market to be in sunset industries that deserve only a lower valuation multiple.

Also, these giants had never been wealth creators for investors.

and also are not fancied by the market as potential wealth creators. , , and are cyclical commodity plays. SBI, though India’s largest bank, also doesn’t have a track record of wealth creation, unlike some private sector majors. But is doing exceedingly well now.

The Bajaj twins,

, , and the IT majors have an enviable track record of incredible wealth creation which justifies their high valuation multiples and market cap.

The crux of the argument is that more than current profits, it is the potential profit and market perception regarding the potential of these companies to create wealth that determines stock prices and returns to investors. Since the churn in Nifty is only going to increase in future, the potential entrants to the Top 20 should be keenly watched.

Dr VK Vijayakumar is Chief Investment Strategist at