Theory of Dividends in Value Investing....

Theory of Dividends in Value Investing:

Dividend season is in full throttle and probably one could base their investment decision on the basis of dividend yield in times when the precarious economic situation and general business conditions are challenged. Because it is in times like this when the business with some sort of competitive advantage and pricing power generally sail through smoothly and dividend for these companies doesn’t gets compromised even during tough times. Though the stock valuation may look depressive because of slowing down of earning growth for extraordinary businesses but the dividend and its yields looks more promising. The classical value investment talks about the intrinsic worth of a business is its present value of all cash flows or the dividend discount model talks about the present value of all future dividends (DDM) which remains applicable in a limited context. But, the fact of the matter is whether it is the investment in bonds or equities, what we can get out of the bond as interest and dividend from equity is the actual return for our principal. And here is the context in which dividend yield comes into play for value investing or for taking proper investment decisions. Difference between investment in fixed income and equities hinges upon the fact that a dividend growth adds on to the yields in the long run and the dividend yield can surpass the bond yield in a meaningful way. But the real context of the difference between equity and fixed income return comes into play when it is permanent investment, not speculative trading, and dividend for years to come, not income for the moment only. For permanent investments into equity market, a stock is worth only what you can get out of it i.e., Dividend.

Experience shows that companies with a competitive moat generally are more liberal with paying dividend out of earnings. The real issue is with the reinvestment of earnings. As the adage goes for certain management that earnings or majority of earnings is required to be reinvested so as aid to tremendous growth potential in the business environment or to keep abreast with its competitive position. But greater experience shows that capex heavy business tends to reinvest majority of earnings and the reinvested capital generally doesn’t bring in greater return on reinvested capital and hence in the process brings in subpar equity return. Majority of the capex heavy businesses tends to reinvest their earnings just to maintain their fixed assets and incremental value addition i.e, in the process Earning Value Added (EVA= RoE-WACC) spread gets eroded significantly. The real crux of the matter is whether the company increases dividend paying power with the reinvested earnings. Companies who can generate return much higher than the Weighted Average Cost of Capital (WACC) with their incremental investments will generate higher equity value in future. If the incremental capital could not generate returns higher than the WACC, it clearly reflects the saturation in the growth dynamics of the business segment and hence it is always prudent in that case to give away as dividend to shareholders (after retaining some to maintain the existing fixed assets) or increase the share of dividends in earnings since the reinvested capital could not add materially to the existing extraordinary return on capital and rather ends up diluting it.

The actual reason for discussing the dividend paying power is the fact that companies with consistent higher dividend payout generally tends to command higher valuation or higher p/e multiples and are also good wealth creators in the long run & the mathematical calculation is given as follows…

Price (Dividend Discount Model) = Dividend/ k-g

Where k=required rate of return i.e, cost of capital; g= dividend growth to perpetuity

The price-earnings ratio for any stock is….

P/E= Price/ Earnings:

Or  Price = P/E * Earnings

Substituting for Price = Dividend/k-g

Or   P/E * Earnings = Dividend/k-g

Or  P/E = Dividend/(Earnings *k-g)

Or P/E = Dividend Payout/ k-g            

(Dividend Payout Ratio = Dividend/Earnings)

Or k-g = Dividend Payout/P/E…………….(1)

For, Dividend Yield = Dividend/ Price

Or Dividend Yield = Dividend/(Earning*P/E)

Or Dividend Yield = Dividend Payout/P/E……………(2) 

or P/E = Dividend Payout/Dividend Yield

Combining both (1&2)

k- g = Dividend Yield and K = g + Dividend Yield

*Hence, it can be concluded that P/E multiple is a positive function of consistent dividend payout ratio and growth and higher dividend payout ratio commands higher P/E multiple.

*Return is a positive function of Growth and Dividend Yield

Companies screened on the basis of higher Dividend Payout and ROE delivering strong CAGR shareholders return over last 10 years:

Sl.no	Company	Payout %	Payout avg %	ROE %	ROE avg %	P/E	Dividend Yield	P/B
1	Colgate-Palm.	69.84	87.03	158.62	95.52	45.71	2.24	60.09
2	Hind. Unilever	63.89	80.46	86.86	86.44	35.76	1.93	32.02
3	Glaxosmit Pharma	85.62	72.81	33.34	31.01	50.94	1.25	16.35
4	ITC	61.18	63.21	35.08	29.73	31.16	1.89	10.8
5	VST Inds.	85.27	62.29	25.59	29.00	17.57	4.95	8.46
6	ALSTOM India	39.43	54.02	26.51	32.08	20.77	1.11	3.87
7	Britannia Inds.	55.40	53.36	54.02	30.04	28.29	1.5	12.41
8	Godrej Consumer	21.58	48.42	25.65	67.87	32.02	0.9	7.25
9	CRISIL	55.59	47.45	46.55	42.93	21.64	2.18	9.59
10	Navneet Publicat	45.96	46.80	22.77	22.89	11.77	3.45	3.06
11	Sun TV Network	60.18	43.94	28.30	28.26	19.97	2.48	5.33
12	ACC	58.76	42.28	16.98	23.73	14.36	2.76	2.54
13	Dabur India	38.85	40.37	41.36	53.08	29.35	1.25	10.23
14	Asian Paints	40.04	39.76	39.39	43.03	34.73	1.21	11.44
15	HCL Tech	36.23	39.09	27.74	27.49	12.56	1.8	3.17
16	TCS	32.30	38.44	40.58	41.08	18.78	1.76	5.84
17	Supreme Inds.	34.64	37.33	37.43	31.61	13.37	2.48	4.18
18	O N G C	30.82	35.83	22.21	23.75	9.64	3.34	1.69
19	Emami	50.57	35.80	37.06	35.90	30.16	1.24	11.56
20	Ambuja Cem.	46.16	34.87	16.92	20.31	14.1	2.4	2.57
21	Infosys	26.72	34.48	27.20	31.51	13.97	2.1	2.95
22	ICRA	39.51	34.34	16.10	19.85	15.67	2.16	2.74
23	Balmer Lawrie	32.48	33.19	20.93	23.25	7.67	2.52	1.32
24	Pidilite Inds.	31.44	32.84	26.76	27.61	28.86	1.03	7.45
25	Kansai Nerolac	20.91	32.47	16.08	20.63	21.92	0.92	5
26	Thermax	22.03	31.93	25.24	32.31	19.29	1.32	3.29
27	GAIL (India)	26.14	30.60	18.47	20.32	8.73	2.94	1.26
28	Tata Chemicals	26.13	29.60	16.34	18.49	8.4	3.52	1.05
29	FDC	28.55	27.96	20.46	22.88	10.41	2.54	2.04
30	Coromandel Inter	32.83	27.90	29.02	35.61	10.08	3.22	2.07
31	Titan Inds.	26.96	26.35	48.19	40.64	30.73	1.02	10.43
32	Godfrey Phillips	23.87	24.35	20.77	18.86	19.69	1.24	3.17
33	M & M Financial	23.52	23.97	23.07	19.85	13.35	1.41	2.53
34	Container Corpn.	25.81	23.89	16.50	21.59	14.51	1.67	2.1
35	Bharat Electron	20.29	20.60	15.33	21.66	11.64	2.04	1.45

* The index (CNX 500) is screened on the basis of following criteria:

•   Payout ratio greater than 20% for last 10 years.
•    ROE greater than 15% for last 10 years.
•  Average Payout Ratio and Average ROE is calculated since 2007.
•   Payout and ROE is taken for FY13.
•   P/E, Dividend Yield and P/B is taken for FY14. 

Paras Bothra

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