The Hindu Business Line : Rising dividends can support valuations

Over the next few years, companies cannot afford to ignore dividends. Investors are looking for higher payouts and need the assurance of a stated dividend policy.

AS AN investor, you would definitely savour this statistic if this stock were in your portfolio. General Electric, the American conglomerate, has paid quarterly dividends without interruption since 1899. Dividends at General Electric have been rising for 29 consecutive years now.

A news report quoting the company's spokesman says that the policy followed by the company is for `dividend growth in line with earnings growth'. In India, though, there are few companies that are as consistent in dividend payments, even over the past five years.

Over the next few years, however, companies cannot afford to ignore dividends. There is even a case for higher dividend growth relative to profit growth, going forward. That could support valuations that have risen significantly over the past few years and produce long-term returns that are superior to debt and beat inflation.

Dividend indifference: The best that can be said about Indian companies is that they have been indifferent to dividends. The investment literature supports this attitude. Theory says valuations are not influenced by dividend policy. Historically, too, dividends have not been important. Even for strategies based on dividend yields, the contribution of dividends to total returns has not been significant.

Going forward, however, it may be different. The average price-to-earnings multiple is now well above 15 times and is almost equal to the average return on equity of 16 per cent. The contribution of dividends to total returns will only increase in the days ahead.

The argument that cash reinvested in the business can earn higher returns than what the investor can manage on his own no longer holds water. Practically, it does not work that way. Cash in the balance sheet often pulls down returns. Managements, therefore, cannot afford to retain cash in the balance sheet that they do not need, though many of them still do. Cash as a proportion of balance sheet had gone up to 17 per cent at the end of the FY 2005 from 10 per cent the previous year.

The dividend yield, though, has steadily declined and is now at an average of 1.1 per cent for a set of 800 companies. These companies form part of the various BSE and NSE indices. Not only has the dividend yield gone down, there is not one company in this list that has increased dividends in line with profit growth in each of the past five years.

This is poor advertisement for Corporate India. Barring a few public sector banks, none of them even has a stated dividend policy. The number of companies in which dividend growth has lagged profit growth is overwhelming. The average dividend payout ratio of 25 per cent is also on the lower side. It could comfortably rise to 33-40 per cent.

Set the standard: Among companies in the set, those that have steadily increased the payout over the years include a number of multinational companies that also earn a high return on net worth. Companies such as Astrazeneca Pharma, Nestle India, Hindustan Lever, Clariant, Pfizer, GlaxoSmithKline Consumer and Cummins India have enhanced dividends to deliver value to shareholders. These companies do not seem to be constrained for growth, either. Some Indian companies that have also shown the way forward include Automotive Axles, Ranbaxy Labs, Hero Honda Motors, Asian Paints, Thermax and a number of banking and non-banking finance companies. These companies, too, are growing fast, and the declaration of dividends has not dampened prospects.

Companies that have held on to profits and not declared dividends include e-Serve, Cranes Software, Sesa Goa, Tata Motors, Moser Baer, ABB, MICO, Aztec Software, Havells India, Amtek India and Sterlite Industries. This is only an indicative list and includes many more. The dividend payout ratio in the case of the indicated companies is less than 20 per cent. Investors, however, need dividends to rise and they also need a stated dividend policy. The earnings yield (inverse of PE ratio) is now at about 6 per cent. If the payout ratio were stepped up to 40 per cent then the dividend yield would rise to about 2.5 per cent.

A growth in dividends each year of about 5-6 per cent, adjusted for inflation, would then offer investors returns of nearly 7.5-8 per cent. This would beat inflation and debt returns by a comfortable margin.

This carrot is necessary to encourage investors to hold on to stocks for a longer-term. That would also reduce the volatility in stock prices provoked by uncertainty about the management's commitment to shareholder value.

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