We are looking a trend of rising dividend payout ratio and buying back own shares in the IT sector. What does this mean to you as an investor?

To us this is like dark clouds gathering over the company’s future outlook. Remember all the finance pundits advising you to invest in the stock market and how your money gets compounded and gain extraordinary returns. Those extraordinary returns and compounding magic is only achievable if you are invested in the business who are giving higher ROE and are reinvesting all or majority of their profits back into the business. which means they are also achieving higher ROE on the reinvested profits.

Let me explain this with an example. Imagine three companies A, B and C. A is reporting ROE of 10% and paying out 50% of their earnings as dividends. B is reporting ROE of 20% but paying out 80% of their earnings as dividend. C is reporting ROE of 20% but paying only 20% of their earnings as dividends. Which company stocks will you invest with?

A

Year Start Equity ROE Profits Dividend % End Equity PE Stock Price
1 100 10% 10 50% 105 10 100
2 105 10% 10.50 50% 110.25 10 105
3 110.25 10% 11 50% 115.75 10 110

 

If you invested in company A for 3 years then your returns including dividends will be 25.75%.

B

Year Start Equity ROE Profits Dividend % End Equity PE Stock Price
1 100 20% 20 80% 104 10 200
2 104 20% 20.80 80% 108.16 10 208
3 108.16 20% 21.63 80% 112.48 10 216.3

 

If you invested in a company B for 3 years then your returns including dividends will be 33.12%.

C

Year Start Equity ROE Profits Dividend % End Equity PE Stock Price
1 100 20% 20 20% 116 10 200
2 116 20% 23.2 20% 134.56 10 232
3 134.56 20% 26.91 20% 156.08 10 269.1

 

If you invested in company C for 3 years then your returns including dividends will be 41.56%.

Every rationale investor will pick company C for investment. The simple answer is because management can see a consistent growth of 16% in their earnings and without damaging its ROE they can afford to reinvest 80% of their profits back into the business and keep using that fund to maintain or grow that growth story. They can use those surplus funds into research, acquisitions and trying new markets and many more things.

But if you are not confident about the extraordinary growth in the earnings then the best thing to do is give that money back to whom it belongs. Which is shareholders of that business.

Big names from our IT sector are doing ethically right by giving back that extra surplus back to their shareholders.

With the buy-back it is completely different subject and deserves its own blog and we will cover that sometime later on our blog. If you have missed out to read on Infosys and why its stock prices are falling down then click here to read that one.

With TCS and Infosys, my judgement on them will be that they were holding those surplus cash for far longer time and did not explored other avenues. The recent capital allocation activities (high dividends payout & buy-back) is pointing towards very rough period ahead of them. If TCS management does not believe in those rough conditions then their actions are not matching with what they are saying. Will leave it over here for your thoughts and insight.