Buffett's $1 Test on ITC

ITC is the one stock today which is splitting investing community in half

It has got attention from even famed traders

As good students of history we will go back to what Mr. Buffett had to say on management efficiency “Unrestricted earnings should be retained only where there is a reasonable prospect – backed preferably by historical evidence or, when appropriate by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.”

1984 Shareholder Letter

Now let’s put ITC’s management to this test, steps are easy

1. Calculate retained earnings of ITC (net profits - dividends)

2. Sum retained earnings for rolling five years

3. Measure market cap delta against every rupee retained

here is the result While 10 years back the results were spectacular, the current results are underwhelming. When management is not able to deploy capital with incremental returns then its best to pay out all earnings as a dividend. ITC paid out > 85% of earnings this year. Assuming the management doesn’t do a course correction and days of the past are well and truly gone, Should we look at ITC stock as a pure-play dividend-paying stock? I will use the most simple method used from 1956, named after Myron J. Gordon of the University of Toronto the dividend discount model Price of shares (P) = Dividend / (Cost of Equity - the growth rate of Dividend) Let’s gather inputs conservatively

1. Dividend = Let’s take an average of last 3 years dividend INR 6.75, note their earnings/dividends have been consistent in last 15- 20 years so it’s safe to take this number

2. Cost of Equity = They are rated AAA by Crisil so they should be able to borrow at 8% ,equity is expensive so we take 10%

3. Growth of dividends = Between 2008 and 2020 dividends have grown at CAGR of 19% but as I said we assumed glorious past is gone, we assume they will be able to grow the dividend by only 7% for foreseeable future, inline with inflation

So P = INR 6.75 / (0.1-0.07) or P = INR 225 At current market price of INR ~200 per share for ITC

• Market is indicating the gaint is past its prime

• The market is assuming management will make poor capital allocation decisions that will destroy the company

• Dividends will de-grow

• The cigarette business will stop growing substantially and dip below the current level

• FMCG business will be a drag and never turn the corner

I personally take comfort in history and hence its added to the scorecard