Tuesday, 29 October 2013 - 20:00

 

Charts

Seed Weekly: Company Profits: Retain or Payout?

We recently looked at the history of payout ratio of all listed JSE companies over the last 50 years and is displayed in the chart below. The payout ratio is the percentage of company earnings that a company declares out as a dividend. This will naturally differ from industry to industry and then down to the specific company.

All things being equal, at the early phase of a business’s life it will tend to require higher levels of capital for growth and as it generates profit, management will want to accumulate that capital in order to invest back into the business for expansion.

As a business or the industry it is in matures, it will have a reduced requirement to reinvest retained profits and so be in a position to pay out a higher percentage of profits as a dividend.

Many investors have as their main focus the divided that they receive on an annual basis. But just as important, if not even more so, for investors are the retained earnings, which is that portion of the profit left after paying the dividend and forms part of the available capital. How a company puts this retained capital to work over the years will be a big factor in determining future profitability.

The portion of annual profits retained by a company each year and not paid out is essentially added to the capital of the company to be used for business expansion and therefore to generate higher profitability.

So, while there is always a focus on the earnings and dividends announced by a company each year, what is often of more importance is how adept is management at allocating the available capital at their disposal in order to generate future profit. In general, where a company has profitable opportunities to deploy available capital on which it can earn a superior return, it should be doing this as opposed to distributing too much of its profits to its shareholders.

Obviously it’s not always easy to compare one business with another. Some are more capital intensive and some far less capital intensive. Heavy industry type businesses, for example Sasol, normally require a much higher portion of yearly profits to be retained and invested into new plant in order to be able to grow future profits.

Other less capital intensive business such as Coronation, have the ability to pay out almost all of their annual earnings as dividend to shareholders and because they have low capital requirements, can still grow their annual earnings. In 2012 they had earnings per share of 217 cents and paid a dividend of 206 cents per share. This year are set to grow earnings by 100%.

A key factor that investors should look for, therefore, is how management have allocated capital and the returns that they have made. In many instances management have destroyed shareholder value by investing into sub optimal businesses. Conversely others like the management of Naspers have utilised the cash from their more mature businesses and invested it into other high growth businesses, earning a superior return on capital for the benefit of all shareholders.

Looking back at the overall payout ratio of all JSE companies then, while this ratio reduced in the 1960’s and 1970’s from above 50%, more recently that percentage has climbed from 35% to around 50%. It could be an indication that companies are finding less opportunities to which to allocate capital, which could in turn result in lower company profitability in the years to come. This is something that needs to be looked at very carefully on a company per company basis.

Kind regards,

Ian de Lange

www.seedinvestments.co.za
info@seedinvestments.co.za
021 914 4966

Tue, 29 Oct 2013

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