The introduction of regulatory norms by the Government of India favoring process patents coupled with the high import tariff and low prices of the domestic drugs has gone a long way in the development of the domestic industry against the multinationals operating in the country. Today, India is not only self sufficient in drugs and formulations, we also export to different countries in Europe and North America.
The Indian leading players in the sector are as follows (some of whom we will study in detail in the relevant sections of the report):
- Alembic Limited
- Ambalal Sarabhai Limited
- Aurobindo Pharma Limited
- Cheminor Drugs Limited (merged with Dr. Reddy ’s Laboratories in FY2001)
- Cipla Limited
- Core Healthcare Limited
- Dr.Reddy ’s Laboratories Limited
- Ipca Laboratories Limited
- Kopran Limited
- Lupin Laboratories Limited (merged with Lupin Limited in FY2001)
- Lupin Limited (erstwhile Lupin Chemicals Limited)
- Lyka Laboratories Limited
- Morepen Laboratories Limited
- Nicholas Piramal India Limited
- Orchid Chemicals &Pharmaceuticals Limited
- Ranbaxy Laboratories Limited
- RPG Life Sciences Limited
- Sun Pharmaceutical Industries Limited
- Torrent Pharmaceuticals Limited
- Wockhardt Limited
Both Indian companies and multinationals are equally prominent in this industry. The MNCs however presence only in the formulations as opposed to both formulations and bulk drugs by the Indian companies. The MNCs that have a presence in the Indian market are:
- Aventis Pharma Limited (erstwhile Hoechst Marion Roussel Limited)
- Burroughs Wellcome (India)Limited
- German Remedies Limited
- Glaxo India Limited
- Infar (India)Limited
- Knoll Pharmaceuticals Limited
- E Merck (India)Limited
- Novartis India Limited
- Parke Davis India Limited
- Pfizer Limited
- Rhone Poulenc India Limited
- SmithKline Beecham Pharmaceuticals Limited
- Wyeth Lederle Limited
Strategic Direction followed by the Companies in this sector
The Indian pharmaceutical industry has grown at a CAGR of around 16% in the 5 financial years ending 2001. Although the growth has dipped from a high of nearly 26% in 1992-93, it has steadily grown since then at around 15-16%. The overall increase in gross sales in the financial year 2002 has been a phenomenal 37% and the PAT has grown in the same period by around 42%. The increase has been specifically impressive for some Indian companies with some increasing as high as 63% in sales and 218% in PAT. The details are provided in the table below.
This impressive performance has been at a time when many of the MNCs in India have not done well. The PAT of Glaxo has fallen by 37.6% and that of Parke Davis by 73.3% in the same period. Hence it is better you study only one of the sectors, as they seem to be driven by different value drivers.
This growth in income has mainly been due to the reduction in the raw material prices that account for nearly 50% of the operating income. The sales and marketing cost has been higher for the multinationals as compared to the Indian companies because of the higher per unit cost in the sales and distribution of formulations as compared to that of bulk drugs. The employee cost has been higher in both sectors due to the quality of personnel required for R&D activities. The cost has however been a little higher for the MNCs as compared to the Indian firms because of the high level of salary.
The operating profit margin for the pharmaceutical industry grew from 14.5% in FY 1996 to 17.2% in FY 2001. The growth has however not been very impressive by the Indian companies rising from 16.9% in 1996 to only 18.4% in 2001. The operating profits of the MNCs however increased from 10.9% in 1996 to 14.5% in 2001. The differences can be attributed to the operating efficiency in the MNCs resulting from rationalization of the manufacturing facilities and the workforce and effective outsourcing. The net profit margin was however volatile in spite of the steady growth in the operating margins. This has been due to the change in the non-operating income and extraordinary items. It has fluctuated from 43% in 1996 to 22% in 2001.
The pharmaceutical industry does not require too much investment into fixed assets. Hence the asset turnover ratio for the industry as a whole has been as high as 2.07 and has been steady around that for the period under contention. The ratio has however been lower for the Indian industries because of the addition in capacities in the recent past. It has been around 1.5 for the Indian companies as compared to 3.5 of the MNCs. As far as the use of capital is concerned, the Indian companies still lack behind their MNC counterparts as can be seen in the lower returns by the Indian companies as compared to the MNCs.
The pharmaceutical industry being a high growth industry has had a low leverage historically. The leverage has somewhat increased for some Indian companies in the recent past due to the huge investments made for the expansion of facilities. The MNCs on the other hand have further reduced their leverage because of the new spate of outsourcing inherent in the industry.
The working capital requirement of the pharmaceutical industry has always been high. The Indian pharmaceutical industry has however witnessed a reduction in the working capital requirement in the recent past on account of effective procurement and management of raw materials. The Indian firms however have not been very efficient at this with a net working capital to operating income ratio of around 40% compared to that of around 25% of the MNCs in India. This is on account of the increasing export orientation among the Indian firms requiring them to maintain high inventory levels in various locations.
Carrying cost in terms of debtors and inventory holding are also different for the Indian firms when compared to that of the MNCs. The debtors holding period id as high as 80 days for the Indian firms compared to around 40 days for the MNCs. In fact the period has increased for the industry as a whole over the years. The period has grown substantially for the Indian firms from 53.1 in 1996 to 79.6 in 2001. Similarly the inventory holding period has also grown for the Indian firms from 83.3 days to 96 days in the same period. The period for the MNCs has however been steady around 76 days. The higher inventory holding period is basically due to the export orientation of the Indian firms requiring them to hold adequate inventory at all times. This results in greater cost for the Indian companies as the imputed cost rises for the firms and hence they become less competitive.
Current market scenario (2002-2003)
The recent trend in the Indian pharmaceutical industry can be described as nothing but revolutionary. With a total size of around Rs 13,000 crore, it is a very strong market with severe competition between MNCs and large Indian firms amidst thousands of small players. There has been a dramatic shift in the emphasis on R&D by the Indian companies. They are now looking at development of original molecules instead of just replicating the prevailing molecules or trying to make extensions of them.
There has been a spate of mergers witnessed in the industry to mark the creation of giants through consolidation. This has followed from the several mergers taking place between the various global giants like Glaxo & SmithKline Beecham etc.
With the expiry of the patent rights of a host of well-known drugs in the year 2005, there is a golden opportunity for the Indian companies to take advantage and become globally competitive. Some of the companies have already proactively taken steps to file for patent rights for those molecules. This will open a large market in the form of US and Europe for the Indian companies. The takeover of the German multinational Bayer by Ranbaxy is just the beginning and there is no doubt that the is lots in store for the Indian companies. New technologies such as genomics, proteomics, and combinatorial chemistry have facilitated drug discovery efforts. Some of the major companies have already been going into research in these areas.
In the light of the increased resources required for various operations in the value chain of the pharmaceutical business, global players are increasingly focusing on their core competencies and outsourcing part of their business activities. They are looking for partnerships to address the evolving market conditions. This reduces the capital required to set up for a research laboratory facility and increase the ROCE of the companies due to reduced fixed cost of operations.
The Indian domestic market is very lucrative with high growth therapeutic segments and the development of new products. The demand for OTC products in India is also increasing because of the easy availability providing a ready market for such drugs. There are also international opportunities for the Indian companies with the exports of generics to the developed countries likely to get a boost with the expiry of the patents soon. Moreover, India has the potential to emerge as a major production base for several global players. The attractiveness stems from the easy availability of raw material and low cost skilled labor in the country. This ha already been identified by quite a few MNCs in India and they have started supplying bulk drugs from India to their group companies overseas.
Given this scenario, the Indian pharmaceutical industry is likely to experience a healthy growth in the short run. Not only will the domestic demand increase, exports are also expected to witness a boom.
Trends in Regulations
The Indian pharmaceutical industry is highly regulated, essentially on three aspects:
- Patents
- Price, and
- Product quality.
The various legislations that govern the Indian Pharmaceutical Industry are:
- The Indian Patents Act, 1970 (and the amendments thereafter),
- Drug Price Control Order (Now replaced by Pharmaceutical Policy 2002)
- The Drugs and Cosmetics Act, 1940
It governs the import, manufacture, distribution and sale of drugs in India. The Drug Controller General of India (DCGI), an authority established under the Drugs and Cosmetics Act, oversees the conduct of clinical trials, is responsible for the approval and registration of drugs, and issuing manufacturing and marketing licenses for the same.
Having signed General Agreement on Tariffs and Trade (GATT) in 1994, India has the obligation of introducing the system of product patents (as opposed to process patents allowed under the Indian Patent Act, 1970) beginning 2005. During the transition period, India is required to adopt the system of granting Exclusive Marketing Rights (EMRs) to applicants of product patents and institute a mechanism for accepting product patent applications.
Position on patents
Government of India (GoI) introduced the Patent (Amendment) Act, 1999, to provide for the grant of EMRs and envisages a mailbox facility for acceptance of product patent applications. The Patents Second Amendment Bill, which was cleared by both Houses of Parliament in May 2002 provides for the extension of the patent term to 20 years from the date of application and incorporates a provision relating to the right of import, besides making some changes in the rules relating to compulsory licensing.
Post-2005, the system of product patents is expected to encourage the introduction of new products by multinationals in the Indian market. The extent of premium would be determined by factors such as market size for the product, price-volume relationship, purchasing power of individuals, and level of competition from existing therapeutically equivalent substitutes.
Intellectual Property Rights (IPR) laws
Product patents will be introduced in 2005, and thereafter, Indian companies would not be allowed to reverse engineer molecules (patented post January 1, 1995) that are under patent protection globally. However, Indian companies would still be able to compete in the domestic market for generics, that is, drugs on which the patent has expired. As the number of drugs that can be reverse engineered would be limited (only molecules patented prior to January 1, 1995 would be allowed to be reverse engineered), the number of product launches in the domestic market may decline. Therefore, the option available to the Indian companies would be to either operate in the generics market or invest in R&D and invent new chemical entities and dosage forms so as to achieve growth in the long run.
The existing products are unlikely to witness any price increase post-2005. Although the reduction in price control coverage (under Pharmaceutical Policy 2002) may provide pricing power to manufacturers, the extent of pricing power would depend on various factors, such as market dynamics, availability of substitutes, the number of players, availability of unbranded generics, and phase of the product life cycle.
Strong intellectual property right (IPR) protection is likely to enhance the interest of multinationals in India and facilitate introduction of new products from their parent company’s portfolio. It is expected that the new products would be priced at a premium, but the extent of premium would be determined by factors such as market size for that product, price volume relationship, purchasing power of individuals, and extent of competition from existing therapeutically equivalent substitutes.
It is also likely that the Indian players who do not have strong R&D capabilities and a diversified product portfolio may become contract manufacturers for other players, Indian as well as multinational. In the long run, introduction of new products through innovative research or in-licensing agreements would be critical for growth. The effectiveness of the IPR protection provided would have a bearing on the introduction of new products and the extent of foreign direct investments in the domestic pharmaceutical sector.
Price Regulations in India: Drug Price Control Order
Various policy initiatives have been introduced post-DPCO 1995 to improve the attractiveness of the Indian pharmaceutical industry, in terms of capital and research investment. Some of them are:
- Industrial licensing requirements abolished for the manufacture of all drugs and
pharmaceuticals except for:
- bulk drugs produced by the use of recombinant Deoxyriboneucleic Acid (DNA) technology,
- bulk drugs requiring in-vivo use of nucleic acids, and
- specific cell/tissue targeted formulations
- Limit on foreign investment through automatic route raised from 51% to 74% in March 2000 and subsequently to 100% of equity share capital.
- Automatic approval provided for foreign technology agreements for all bulk drugs, their intermediates and formulations except for those produced by the use of recombinant DNA technology, for which the procedure prescribed by the Government would be followed.
- The Government has also increased the fiscal incentives for R&D expenditure incurred by the pharmaceutical companies. The Government has extended the facility of weighted deductions of 150% (from income while computing the corporate tax liability) of the expenditure on in-house research and development to cover as eligible expenditure, the expenditure on filing patents, obtaining regulatory approvals and clinical trials besides R&D in biotechnology.
In addition, The Pharmaceutical Policy 2002 has made provisions for the following.
- Exemption from price control for a new drug developed through indigenous R&D for a period of 15 years from the date of the commencement of its commercial production in the country.
- Exemption from price control for: (i) a drug manufactured using indigenously developed process; and (ii) a formulation with a new delivery system developed indigenously and patented under IPA.
- Reduction in span of price control. For bringing a bulk drug under price control, two criteria would be considered (i) mass consumption nature of the drug, and (ii) absence of sufficient competition in such drugs.
- For a particular bulk drug, the MAT value for an individual formulator would be the basis for calculating his market share in the retail trade. The criteria for determining mass consumption nature of drugs may lead to identification of a large number of bulk drugs. The criteria for bringing the bulk drugs under price control are as follows:
- Bulk drugs with annual turnover of over Rs. 250 million where the market share of a single brand formulation is equal to or exceeds 50% would be under price control.
- Bulk drugs with annual turnover between Rs. 100 million and Rs. 250 million where the market share of a single formulation exceeds 90% would be under price control.
- Bulk drugs with annual turnover less than Rs. 100 million would be outside the purview of price control.
- Mechanism for fixing the prices of bulk drugs and formulations has remained unchanged. The only change that has been made in the pricing mechanism is the discontinuation of the pricing of bulk drugs in the case of a new plant at 12% marginal costing (as under DPCO 1995).
- The Department of Chemicals and Petrochemicals had set up a committee under the chairmanship of the Director General of Centre for Scientific and Industrial Research (CSIR) in 1999 to strengthen the R&D capabilities of Indian pharmaceutical companies and enable them attract higher investments. This committee, called the Pharmaceutical Research and Development Committee (PRDC), has suggested that a company to be qualified as an R&D intensive company must comply with the following conditions (known as ‘Gold Standards’):
- It should invest at least 5% of its annual turnover in R&D.
- It should invest at least Rs. 100 million per annum in innovative research, including development of new drugs and new delivery systems.
- It should employ at least 100 research scientists in R&D in India.
- It should have been granted at least 10 patents for research done in India.
- It should be owning and operating manufacturing facilities in India.
Value Drivers in the Indian Pharmaceutical industry
The Value Drivers in the Pharmaceutical industry can be broadly divided into three categories and studied as under:
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Economic Variables: There are a number of macro-economic variables that affect the value of any company. For the particular case of the pharmaceutical industry, we would in addition to the generic factors like interest rates, exchange rates etc, also need to consider the excise duties applicable to the sector, any subsidies that are offered among other things. These value drivers can be looked at further as a split between those that affect the sales and those that affect the costs. There are regulatory effects that would come in the category of sales affecting factors, such as the delineation of a drug into the over the counter or by prescription only category would have a definite impact on the sales. On the other hand, changes in duties, subsidies given to certain imports and production of certain drugs would cover the gamut of factors that affect the costs.
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Financial Value Drivers: These are the value drivers that have a direct impact on Free Cash flow. The various ways in which these financial value drivers can have an impact are in terms of the Sales growth, Operating Profit Margin, Tax Rate, Working Capital Investment, Capital Expenditure and the Cost of Capital.
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Non-financial Value Drivers: These are non-balance sheet measures. Non-financial value drivers are generic drivers such as: Management quality, Employee quality, Innovation, Branding, Customer satisfaction etc. The non-financial drivers are industry specific and their relative importance depends on the industry. These non-financial value drivers affect financial value drivers and hence the FCF.
The various non-financial value drivers are discussed below:
1) Research and Development: Research and Development is the critical differentiating factor for pharma companies worldwide. However, with a liberal patents regime in India, till now Research and Development was not given the merit due by Indian companies. With product patents being recognized in India starting 2005, process reverse engineering, the mainstay of domestic pharmaceutical R&D till recently, will be permissible only for molecules patented before 1995. Thus, Indian companies, particularly those that had relied on finding alternative manufacturing processes for making new patented drugs launched overseas, would no longer be able to do so. Therefore, these companies would need to take steps to refurbish their product lines, otherwise their product portfolio, and therefore, sales could stagnate. Realizing this, the R&D focus of most Indian players has shifted towards discovery of new chemical entities (NCEs) and novel drug delivery systems (NDDS) for existing drugs. Expenditure on R&D is the most important criterion for success in the pharmaceutical industry. It is imperative for companies in this industry to be able to continually introduce new and more effective products at regular intervals. Companies with effective R&D operations are able to introduce products at a faster pace, which helps them maintain higher growth rates and margins. Some of the high-growth companies like Ranbaxy, Sun Pharma and Dr. Reddy’s can partially attribute their success to their strong focus on R&D.
Indian companies have the advantage of availability of cost-effective technically qualified manpower. Particularly in R&D, the availability of manpower is crucial. It needs to be noted that in the pharma sphere, as of now, the Indian manpower does not possess cutting edge knowledge, however, it is only a matter of time before the influence of other spheres and a robust education system takes effect. Long-term funding in India is easily available as compared to most other countries. Long-term funding determines the amount of R&D expenditure that a firm can invest in as the gestation period for R&D expenditure is usually very long, of the order of 5 years or more. The various alliances that Indian companies have entered into over the past many years are expected to provide them with some amount of access to technology platforms. However, this is one area where substantial progress needs to be made in the sphere of R&D.
As of now, the normal Indian pharma company spends around 2% of its sales on R&D. This amount is pittance by international standards. Therefore, with the changing market scenario, Indian firms need to invest heavily into R&D. This need also derives from the increasing necessity to serve international markets where the patent laws would warrant the need for product patented formulations.
The graph above shows the R&D expenditures of some of the major players in the Indian pharmaceutical sector. We can clearly see that Wockhardt and DRL are two companies that have increased its proportion on R&D spending substantially over the past few years. Additionally, there are a few other companies like Torrent and Alembic that have also had high R&D spends in the past few years. It is also interesting to note that Cipla that was historically one of the strongest R&D spenders has been reducing the R&D spend as a proportion of sales. This move is surprising and a more detailed analysis is an aspect for future work.
Considering the P/E ratios, the ratio for DRL has shown an increasing trend over the period from 2000-2002. This supports our contention that the inputs by DRL into the R&D have been fruitful, hence R&D is indeed an important value driver in the pharmaceutical industry.
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Manufacturing process: Development of manufacturing capabilities has not been an area of importance as the costs involved in R&D have been much greater than the commercial production costs as also the importance of patents. The increasing complexity of chemical structures of the drugs has driven the cost of production of such drugs upwards. For Indian companies, competing on the basis of lower production costs, the following factors are key for an effective manufacturing operation as production efficiencies become important:
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Technological competence
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Procurement efficiencies
- Access to raw materials
- Containment of material costs
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Maintenance of quality
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Product Portfolio: This will be measured in terms of both how broad is the portfolio as well as the stages of development that the products in the portfolio are. Breadth of the product portfolio ensures risk mitigation as this ensures that even if one of the products has a problem, the company on the whole will be less affected. Preference for mixed portfolio with a single supplier. Dr.Reddy’s, Sun Pharmaceuticals & Wockhardt have improved product mix. The following are the various distinctions into which we can split the product portfolio:
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Bulk drugs and formulations: In the bulk drugs business the focus is on cost competitiveness. In formulations brand building and marketing network are important. Consequently, many large Indian companies are shifting their focus on to formulations even in the exports markets. Companies like Dr.Reddy’s, Sun Pharmaceuticals and Wockhardt have effectively changed their product mix to improve their margins. The main characteristics that determine the effectiveness of a product portfolio are:
Therapeutic profile of portfolio: Differences in the demand pattern, lead to different therapeutic segments presenting different growth patterns. For example, increasing incidence of lifestyle related ailments has led to a rise in the demand for the relevant drugs. Also, sales of all molecules don’t grow at the same rate.
Portfolio age: Pharmaceutical products have very short life cycles. Realizations from particular chemicals are inversely linked to its age. Introduction of new products and the age of products in the portfolio are important determinants of a company’s growth and profitability prospects. Some companies such as Cipla and Sun Pharma have been able to register relatively high sales growth because of the comparatively larger share of new products in their portfolio. Further, launch of new products in high-growth therapeutic areas where companies already have a significant presence enables them to offer a more comprehensive range of drugs thus boosting the company ’s image with physicians.
Differentiated products: Products based on new delivery system enables companies to differentiate themselves from others in the competitive market. This strategy has been employed by a few large players in India and is referred to as NDDS (New Delivery System).
Portfolio of patented products: Multinational pharmaceutical companies usually have a large range of under-patent products in their portfolios. The associates/subsidiaries of such companies have been hesitant in bringing these patented products into the Indian market because of the system of process patents prevalent here. With the system of product patents being introduced, the multinationals are likely to be encouraged to bring their latest products into the Indian market. This is expected to help in expanding the market and strengthen the relative position of multinationals as well.
4) Alliances are the defining element for much of the Indian pharmaceutical industry. The importance of alliances has to do with the lack of availability of top-tier technology and research for the Indian firms. These alliances are crucial for the foreign partners as these provide them with avenues to explore the Indian markets in less risky ways.
5) Approval of International Agencies: The Indian pharmaceutical companies have recently tried to obtain approval from the international regulatory authorities such as US-FDA, UK-MCA, SA-MCC and other reputed international inspection agencies. This is very important for the Indian companies since these approvals are considered to establish the companies’ claims of world-class standards. This approval does not add value to the companies existing in US since it is mandatory there to obtain the approval of FDA. Since most Indian pharmaceutical companies are not up to the global standards, the voluntary attempts of the company to get it approved by the international agencies shows their willingness to meet the world standards. The approval would mean a critical differentiation factor from the other companies. This approval would also give a company a better chance to have alliances since its quality is proved. It would also give the customers worldwide a confidence in the company. Hence this would increase the valuation for an Indian pharmaceutical company.
6) Sales and Marketing: In the formulations segment, as has been discussed earlier, the sales and marketing has an important role to play. The marketing function primarily involves product promotion through direct interaction. Field forces comprise Medical Sales Representatives (MSRs), who visit doctors and promote their products through samples and other promotional items. The strength of a company’s brand equity or the strength of its brands affects the interest levels of doctors. The marketing intensity, i.e., number of MSRs per territory depends upon the territory ’s market potential, competitive activity in that territory and the desired brand penetration in that territory. The following are the elements that need to be considered when evaluating the effectiveness and the requirement of the sales and marketing division of a pharmaceutical company:
Target market: In most therapeutic segments, price realization is higher in the international market than in the domestic market. As a result, companies with an export thrust have relatively higher margins. This has encouraged companies such as Ranbaxy, Dr.Reddy ’s and Cipla to alter their market mix in favour of exports.
Brand strength: In the OTC segment, products are known by their brand names, and therefore, brand building is very crucial for them.
Access to distribution network: This is important for players in the formulations segment, especially in the case of manufacturers of products with high levels of competition. Some pharmaceutical companies have increased their turnover on the basis of their distribution strength. In the Indian market, rural distribution capability is also of significance because of the considerable demand for drugs in some specific therapeutic segments in the rural areas. Establishing a network in the interior parts of country is a difficult and expensive task, and has proved daunting for many multinationals. Consequently, many multinationals have entered into alliances with Indian companies that have established strong marketing networks.
The importance given by a company to the sales and marketing can be analyzed by looking at the two graphs shown above, separately for the sales and the advertising. One can clearly see that Zandu has been one of the most aggressive as far as advertising is concerned. This can clearly be understood from the fact that Zandu is very strong in the OTC drugs that are sold without prescription and hence for these drugs awareness among the consumers is a critical success factor.
Conclusions
One of the tests of whether a particular value driver is a value driver or not is the testing on the movement in the P/E ratio of the company that has actually used that driver over the years. In the table below we have calculated the P/E ratios of 20 companies over 4 years to study the same.
The P/E ratio has been calculated by dividing the year ending price of the stock of the company on the BSE by their EPS of that year. One limitation in this computation is the differences in the book closing of the various companies. Some of the ratios have not been calculated, as no data was available for the period.
It needs to be noted that the beginning of the year 2000 was an abnormal as the BSE Sensex shot up to 5000 and stayed there for some time and collapsed drastically due to the boom and bust in the IT company stocks. Hence, for our analysis we have not taken the 1999 ratios into consideration.
DRL is one company that has put into place most of the value drivers that have been discussed above. The company has clearly seen the effectiveness of these value drivers, via the creation of positive growth patterns in the P/E ratios, even when the industry as a whole was seeing a declining trend. The other examples that we can see, such as Wockhardt, that has seen a declining trend in the P/E ratio, but one that is definitely better than the industry averages can be seen as an example of the value driver of R&D. Wockhardt has put a lot of attention on R&D and reaped the rewards.
In this way by considering a number of time periods and doing a detailed analysis and doing a regression analysis, it is possible to determine the true value drivers of the industry and their relative importance. However, the interplay of a number of macro-economic variables and problems in dissociating one particular factor make the task difficult.