If the banking sector acts as a back bone to an economy by providing the required liquidity, the infrastructure sector provides the main infrastructure to an economy by providing the growth path to other sectors. While all the developed economies already have world class infrastructure in place, infrastructure in the emerging economies is not up to that mark which indicates huge growth potential in the future.
Here in this section we will try to specify all the important aspect a financial analyst should know before evaluating an infrastructure company.
Key points about Infrastructure Sector
The infrastructure sector is divided into some important categories based on the type of development and work they normally do. The construction sector can be broadly classified into three categories. They are
To analyze an infrastructure company an analyst should know the following details of an infrastructure company.
Order book of an infrastructure company refers to the orders a company has or working on which is the main source of future revenues. As the infrastructure business is mainly done through orders, the order book provides an insight about the size and future growth of an infrastructure company. The order book may span for very long term, can be spread for even 20-30 years. The bigger order book an infrastructure company has, the better will be its growth in the coming future. That’s why analysts use this method to project the future sales or revenue of an infrastructure company provided it will be able to complete all the future projects within the proper time period.
The revenue recognition from the order book depends on the execution capability and the execution period. If a company cannot complete the projects on its order book, it won’t be able to recognize revenue for the same and with time there will be chances of loosing order book deals.
The company should have all the necessary infrastructure and financial ability to complete all the projects within the proper time period. The faster it will complete the projects, faster it will be able to recognize revenue for the same. Also completing projects within proper time will help it to gain more projects going forward which is very much necessary to expand the business.
The nature of projects on the order book is also considered to be an important parameter for an infrastructure company. The profitability, execution period, initial investment, risks etc varies with the nature of the projects. Proper order mix helps infrastructure companies to reduce overall risk by spreading business across different sectors. Real estate sector requires lower initial investment compared to other capital intensive sectors like power sector or road construction sector etc. The analysts should look at order mix in the order book to evaluate any infrastructure company.
Unlike the banking and software sector, the infrastructure sector requires different types of raw materials for production and development purpose. The cost of cement, steel, and other necessary materials affects the profitability of an infrastructure company and all these costs depend on the inflation and other parameters. An analyst should consider all the related raw material costs before calculating the profitability of a company. High inflation increases their cost significantly and hurt their profit margin.
Another major expense of an infrastructure company is the wages of the workers which changes with the labor law and inflation. Very high increase in the average wage of the workers affects the profitability.
The infrastructure sector is one of the most interest rate sensitive sectors as most of the constructions are either demand driven and are funded by borrowed funds. Increase in interest rate reduces the demand for real estate sectors as individuals find it costlier to take home loans, thus decreases the demand for homes. At the same time, the infrastructure companies borrowing money to fund any ongoing project find it tough to borrow fund at lower rate. Any increase in interest rate affects the infrastructure sector significantly.
Key Operational and Financial Parameters
Infrastructure companies are considered to follow poor disclosure standards which lead to poor corporate governance. The whole responsibility of following better corporate governance and disclosure standards depend on the management of the company. An analysts working on an infrastructure company should consider the management capability and ethical values as key parameters.
As we have already specified the importance of order book, this is one of the most important key operational and financial parameter analysts should consider while calculating the growth projection and future forecast of profit. The higher the order book; better the chances of converting them in revenue and generating more profit in future.
With the order book, the segment presence is also very important parameter to evaluate an infrastructure company. The segments it operates have a direct impact on its revenue and profit margin. Some of the segments are having lower risk like building real estate and commercial complex etc. and some of the segments are having higher risk like factories, plants etc. Higher risk increases the uncertainty of receiving expected revenues in future.
Land bank is considered to be an important parameter for real estate companies as it always appreciates in value and company does not need to buy land at a high price to build housing sector. The price of land banks is also reflected in the valuation of an infrastructure company. Having significant land bank at the prime locations always increases the valuation on the company.
There are some important financial and valuation ratios which should be considered while evaluating an infrastructure company. The mostly used financial and valuation ratios are
Debt to Equity Ratio
The infrastructure companies use to take high debt to fund the initial investment requirement which is normally very high. For any big constructions like road, airport, bridge, flyover etc. the initial investment requirement is funded by debt and the interest is paid from the income of that particular construction. So the Debt-to-Equity ratio is a key financial ratio which should be used to evaluate an infrastructure company. It is calculated as
Debt-to-Equity Ratio = Total Debt /Total Shareholders’ Equity
Lower the Debt-to-Equity, better the financial health of the company as lower debt results in lower interest payment from the profit.
Interest Coverage Ratio
Because of high initial investment and high debt, another important financial ratio used is Interest Coverage Ratio which determines the company’s ability to pay the interest on its outstanding debts from the income. It is calculated as
Interest Coverage Ratio = Earnings before Interest and Taxes (EBIT) / Interest Expenses
Higher the Interest Coverage Ratio, better the company’s financial health and ability to pay the interest from its income.
Operating margin is the most important financial parameter to denote the profitability of an infrastructure company. It denotes the company’s ability to run the business with low operating expenses. It is calculated as
Operating Margin (%) = (Operating Profit/ Revenue) * 100
Higher the Operating Margin, better the company’s ability to run the
As the valuation price multiple, P/E ratio is used here to evaluate the share price of an infrastructure company. The reasons behind the same
The book value (BV) can be manipulated very easily by manipulating the price of the land bank. The sales revenue can also be manipulated by changing the revenue recognition procedure. With high order book in hand, manipulation in sales revenue is very easy. Cash flow cannot be considered as an important valuation parameter. That’s the main reason other Price multiples P/S Ratio, P/BV Ratio and P/CF Ration are not widely used for an Infrastructure company.
The earnings depend on the revenue recognition procedure by the company and the interest payment, which can be less manipulated by an infrastructure company.
Because of these reasons Price-Earnings Ratio (P/E) Ratio is primarily used to check the valuation of share price of an infrastructure company. If the P/E ratio is higher than the peer companies then the market share price is overpriced, if it is lower than the peer companies, then the market share price is under priced.