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
Calculate retained earnings of ITC (net profits - dividends)
Sum retained earnings for rolling five years
Measure market cap delta against every rupee retained
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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
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%
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