" ...we prefer equity to debt as it works out cheaper for us..."
-promoter of a company that raised money in the 94 IPO boom
Nothing could be further from the truth.
It's true that, unlike debt, there is no fixed cash flow that a firm must compulsorily give to its shareholders on a regular basis. But that in no way means that equity is cheap. In fact, equity has a cost and the cost is real.
Dividends and its offshoots
Dividend payout is the most visible cost, as it represents a company's cash outflow to shareholders every year. By the way, dividend is defined as the distribution of earnings to shareholders during a year.
For a minute, let us assume it is dividend that is cost of equity
A company normally announces dividend as a percentage of the face value of its share. Hence, when HLL says it is paying a dividend of 290%, it actually means that it is paying a dividend of Rs2.9 per share (remember the face value of HLL is Re1 now)!
But don't we pay Rs215 to buy a share of HLL? So we earn Rs2.9 on Rs215 that we invest! That works out to 1.35%. Incidentally, this is called 'dividend yield'
What? For bearing all the risks associated with equities we get less than a savings bank deposit return? Are we missing something?
Of course we are...
A few steps back before we take the big leap forward
Right at the beginning, we discovered that the investor has his eye on the big stakes. He is willing to risk his capital today in an investment that he believes will earn him returns over the life of the business. He believes that in future such an investment will yield much superior returns to that of a debt investment.
Hence, the price of the stock at any given point in time is the value that is placed on the expected future stream of dividends from the business over its lifetime. So when you sell a stock you are effectively selling the right to future dividends that you could have earned from the stock.
Now, does current dividend indicate future dividend flows?
No. This is because dividends in future are expected dividends. The actual dividends might be higher or lower, depending on profits for that year and the profits the company wishes to plough back into its business to earn higher profits in future years.
A small aside -- the proportion of profits that a company pays out in a given year is called 'dividend payout ratio'. And the proportion of net profit that it ploughs back into business is its plough-back ratio. Since HLL paid out Rs638cr as dividend out of its profits of Rs1070cr in FY2000, its dividend payout ratio was 60%.
So as the company grows in size, enhancing its ability to earn more profits and pay higher dividends in the future, the value that the market places on the future dividend stream increases. In other words, the market price increases. We all know this as 'capital gains'.
We know that we buy stocks for capital gains but, in essence, we still invest in stocks for the future dividend stream that is captured by the 'capital gains'.
In short, stocks are bought for their dividend yield and their capital gains.
Thus, the expected rate of return from equity is:
Expected rate of return = dividend yield + capital gains
Since this is what shareholders expect from their investment, a company has to deliver on these counts in order to service its equity. This is its cost of equity.
At this stage, we could take a break to ponder over an age-old wisdom -- Isn't 'A bird in the hand is worth two in the bush'?
Is the present dividend (which is safe) always preferable to future dividends (which are risky)?
Reliance Industries (has a dividend payout ratio of 17%) has a good track record of paying dividends. Infosys, on the other hand, pays out only 10% of its net profit as dividend. Its dividend payout is 10% and plough-back ratio is 90%. Infosys is held in higher esteem by the market. Why? Infosys has a return on net worth (RoNW) of 42%. Its net profit is growing at over 80% year on year. If instead of paying out this profit as dividend, the company re-invests a substantial portion back into its business, then this capital could earn an additional return next year.
For instance, in FY2000, Infosys ploughed back Rs264cr (that's 90% of its net profit) into its business. This will earn an additional return of about Rs110cr (simply 42%*264) this year even if the company maintains its RoNW. Thus, on this count alone the re-invested amount will yield a growth of 38% (simply the plough back ratio * RoNW or 90%*42%) in its earnings.
Now let us work out similar numbers for Reliance. Reliance has a RoNW of 23%. It re-invested 83% of the net profit, that is Rs1983cr, in FY2000, into its business. Therefore, this incremental amount can generate a return of Rs464cr, implying a growth of about 19%.
Thus a Rs100 re-invested in Infosys will compound at the rate of 38% while that in Reliance will compound at the rate of 19%.
According to finance gurus, Brealy and Myers, "This is because the reduction in value caused by reduction in dividends in the earlier years is compensated by the increase in value caused by the extra dividends in later years."
Simply, investors in such high-growth firms are willing to forgo dividends in the early years in the hope of enjoying much higher dividends in future years. As a result of this the stock prices rise. In other words, shareholders are indifferent, so long as a lower dividend yield is compensated for by a higher capital gain.
But how do you calculate cost of equity?
Familiar path that we treaded while discussing "Risk Premium" So Capital Asset Pricing Model (CAPM) must be the answer.
Thus the cost of equity, ke = Rf + beta (Rm-Rf)
Where ke = cost of equity,
Rf = the risk-free premium,
Rm = market return.
If we plug in the values for HLL in the above formula, its cost of equity works out to 21.9%.
So the next time someone tells you that equity is cheap, you know better!
A company should earn a return on equity that is at least greater than the cost of its equity. Thus, cost of equity sets an important standard to evaluate the way a company does its business.
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