Franchise Value vs. Breakup Value: What Actually Drives Multi-Decade Compounding

Investors often get dazzled by companies with exceptionally high Return on Equity (ROE). On paper, a business that generates 50%, 80%, or even 100% ROE seems like a perfect compounding machine. But here’s the uncomfortable truth:

High ROE alone does not create wealth. Growth does.
Without earnings growth, even the best company can become a poor investment—especially if you overpay.

To earn a realistic 15–20% CAGR, you need more than just efficiency metrics. You need a business that can grow earnings consistently, reinvest capital at high returns, and still offer a reasonable earnings yield at the price you pay.

This article explains why growth matters more than ROE, breaks down the simple math behind long-term returns, and illustrates the idea through real-world style case studies.

Why Growth Matters More Than Just High ROE

ROE tells you how efficiently a business converts shareholders’ capital into profits—but it says nothing about whether those profits are growing.

A company can have:

100% ROE
A tiny equity base
Positive reputation
Zero growth opportunities

And it can still produce flat earnings of ₹500 crore every year.

Now imagine paying 40–50× P/E for such a company. Your earnings yield becomes:

At 40× P/E → 2.5%
At 50× P/E → 2%

With no growth, your expected return also hovers near 2–2.5%. That’s barely better than a savings account—and dramatically worse than inflation.

Eventually, when the market realises that earnings are not growing, the P/E compresses to a more normal 15–20×, causing massive value erosion.

This is why high ROE alone can be a trap.

The Math Behind Long-Term Returns

A simple formula explains expected long-term stock returns:

Return ≈ Earnings Yield + Earnings Growth

Ignoring major changes in valuation, this formula holds surprisingly well.

Example:

Earnings = ₹500 crore
Market cap = ₹20,000 crore
P/E = 40
Earnings yield = 2.5%

If earnings do not grow, your return ≈ 2.5% per year.

But if earnings grow 10–15% annually, then:

2–2.5% (earnings yield)

10–15% (growth)
= 12–17.5% CAGR

Add dividends of 3–5%, and you approach 18–20% CAGR.

That’s the magic of franchise value—the ability to reinvest capital at high returns and grow the profit base consistently.

Franchise Value vs Breakup Value

Understanding these two sources of value is crucial:

Breakup Value

The worth of assets if you dismantle the business and sell everything piece by piece.

Franchise Value

The premium created because the company can:

Earn high returns on capital
Sustain growth
Reinforce its competitive advantage
Reinvest profits at high ROE/ROCE
Maintain pricing power

This value comes from brand, distribution, customer trust, and operational excellence—not physical assets.

Companies with strong franchise value compound earnings for decades, while “asset-rich” companies without earnings power often destroy value.

Case Study 1: Great Franchise + High ROE + Consistent Growth

(Nestlé India Style Example)

Consider a leading FMCG company such as Nestlé India. It has:

Iconic brands
Strong pricing power
Wide distribution
High and stable ROE
Growing earnings
Growing dividends

Its assets—factories and warehouses—aren’t the real engine of value. The real power lies in:

Brand trust
Customer loyalty
Repeat buying
Massive distribution networks

This allows the company to reinvest capital at high returns for long periods.

Even though the stock often trades at a premium P/E, long-term investors have earned 15–20% CAGR because the earnings base didn’t stay flat—it compounded year after year.

This is franchise value in action: high returns + scalable growth + durability.

Case Study 2: High P/E but No Growth

(The Classic “High ROE, No Franchise Value” Trap)

Now imagine a hypothetical company that:

Earns ₹500 crore every year
Has 100% ROE due to a small equity base
But no ability to grow

The stock trades at 40–50× P/E, giving buyers a tiny earnings yield of 2–2.5%.

For the first few years, the market remains excited. But eventually, investors realise:

There is no growth runway
The company has no scalable source of value

Valuation drops from:

50× → 20×
or
40× → 15×

This alone can cut the stock price in half, even though the business remains profitable.

This is the “high P/E, no growth” trap—mathematically impressive ROE but no compounding engine.

Case Study 3: Asset-Rich Company Becoming a Value Trap

Now consider the opposite scenario.

A company has:

Book value: ₹20 per share
Market price: ₹15

This looks cheap—you’re buying ₹20 of assets for just ₹15.

But if the company is:

Loss-making
In a sunset industry
Over-leveraged
Unable to monetize its assets
Lacking any catalyst

Then this “cheapness” is an illusion.

Many real-world value traps come from sectors such as:

Old-economy manufacturing
Commodity businesses
Over-leveraged infrastructure
Declining media companies

These businesses have large physical assets but shrinking earnings.

Without a turnaround plan or asset sale, such companies destroy value for years, and investors suffer permanent capital loss.

A Practical Investor Checklist

Is the ROE sustainable and clean?

A high ROE number means nothing if it’s artificially inflated. Many companies show temporarily high ROE due to:

High leverage (excessive debt increases ROE artificially)
One-time gains (asset sales, tax reversals, fair-value gains)
Undersized equity base (low equity makes ROE look inflated)
Financial engineering (buybacks done only to shrink equity)
Cyclically high margins (commodity and cyclical businesses often show this)

A clean and sustainable ROE usually comes from:

A strong brand
Pricing power
High-margin products
Low-cost operations
Consistent return on capital (ROCE)
Stable or growing equity base
Low reliance on debt

If ROE swings wildly year to year—or depends heavily on debt—it’s a sign the business lacks true structural strength.

Can the company reinvest profits at high returns?

The biggest determinant of long-term compounding is the reinvestment runway.

Ask:

Can the company deploy profits back into the business at the same high ROE?
Are there new product categories, new geographies, or new customer segments to expand into?
Is the market size large enough (or growing fast enough) to support 10–15% yearly growth?
Is the management capable of scaling operations efficiently?

Even a company with 40–50% ROE becomes stagnant if:

The market is saturated
Growth opportunities are limited
Competition erodes margins
Regulatory barriers reduce expansion

On the other hand, a company with moderate ROE but a huge reinvestment runway may deliver far better long-term returns.

Growth + high ROE = compounding engine.

Does earnings yield + earnings growth meet your return target?

Use the simple rule:

Expected Return ≈ Earnings Yield + Growth Rate

Earnings yield is the inverse of P/E:

50× P/E → 2% yield
40× P/E → 2.5% yield
20× P/E → 5% yield
15× P/E → 6.6% yield

Now add expected long-term earnings growth:

If a business can grow only 5%, you can’t pay a 50 P/E.
If it can grow 15–20% for years, a premium valuation may still be justified.

Your target should be:

15–20% expected CAGR combining earnings yield + earnings growth + dividends

If this math doesn’t add up at your buying price, the stock is not worth your capital—no matter how “high-quality” the brand is.

Is the “cheap” stock actually a declining business?

Many retail investors fall into this trap:

“The stock is below book value. It must be cheap.”

But low P/E or low P/B often signals deeper problems:

Persistent losses
Declining industry
Heavy debt
Aging manufacturing assets
No pricing power
Falling market share
Corporate governance issues

A stock is cheap for a reason.

Ask:

Is there a clear turnaround strategy?
Is management improving capital allocation?
Are there new growth catalysts (asset sale, new management, product pivot)?
Is profitability recovering?

If none of these exist, then the low valuation is not an opportunity—it’s a warning.

“Cheap” alone is not an investment thesis.

Does the company have real franchise value?

Franchise value is what separates a compounder from an average company.

A strong franchise typically has:

Moats

Strong brand
Patents
Large distribution network
High switching costs
Network effects
Cost advantages

Pricing Power

Ability to raise prices without losing customers
Sticky customer behavior
Premium positioning

Durability

Can the competitive advantage last 5, 10, 15 years?
Or is the business vulnerable to disruption?

Repeatability

Can new capital be deployed at similar high returns?
Can the business scale without proportionally increasing capital employed?

A company with franchise value keeps increasing earnings without needing massive new capital—the perfect setup for compounding.

Final Takeaway

The stock market rewards earning power, not just assets or accounting ratios.

To build long-term wealth, focus on companies that can:

Maintain high ROE/ROCE
Grow profits consistently
Reinvest at high returns
Justify their valuations through real, durable franchise value

High ROE alone is not enough.
Growth alone is not enough.
Cheapness alone is definitely not enough.

But high ROE + growth + franchise value + sensible valuation?
That’s how you build 15–20% CAGR wealth over the long term.