Case 016DCF and intrinsic valueCore

Value Sarthal Power, a regulated utility, with a dividend discount model: dividend just paid Rs 12, growth 5%, cost of equity 11%, allowed return on equity 15.5%, payout 80%. The model says about Rs 210. Is the growth consistent with what the company retains?

The situation

Sarthal Power transmits and distributes electricity under a regulator that allows it a return on equity of 15.5% on its regulated asset base. It earned Rs 15 a share last year and paid a dividend of Rs 12, an 80% payout it has held for years. Its asset base grows only when it invests, and it funds its equity share of new investment from retained earnings; it has not issued shares in a decade.

A colleague's model grows the dividend 5% a year forever at an 11% cost of equity and values the shares at about Rs 210. The allowed return and the regulatory framework change from time to time, so treat 15.5% as the case's figure and confirm the current order before using any real number.

Your task

Check the colleague's number. Is 5% growth consistent with an 80% payout, and what is a consistent value?

Quick check

At an 80% payout and a 15.5% return on equity, how fast can Sarthal grow without issuing shares?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

No: an 80% payout funds only 3.1% growth, so Rs 210 counts the same rupee twice, once as a dividend and once as growth. Held consistent, the value is about Rs 157 at the current payout, or about Rs 178 if Sarthal cuts the payout to 68% to fund 5% growth. Retaining more is worth it here because the allowed 15.5% is above the 11% cost of equity.

Step 1Why must growth match what the company retains?

A farmer who sells 80% of the harvest and keeps 20% as seed can only plant a slightly bigger field next year. Selling 80% and planning for the harvest to grow as though half were kept does not work. For a company that does not raise new equity, sustainable growth equals the retention ratio times the return on equity. Sarthal retains 20% of profit and earns 15.5% on it, so equity, the asset base and profit can grow 3.1% a year. A utility is the cleanest case, because it cannot grow earnings except by adding regulated assets.

The relationship
g=b×ROE=(1−0.80)×15.5%=3.1%V0=D0(1+g)ke−gg = b \times ROE = (1 - 0.80) \times 15.5\% = 3.1\% \qquad V_0 = \frac{D_0(1+g)}{k_e - g}
bretention ratio, the share of profit not paid out
ROEthe allowed return on equity, 15.5%
D0dividend just paid, Rs 12
kecost of equity, 11%
What it says in wordsGrowth that is funded from within is the share of profit kept times what it earns, and the dividend model values next year's dividend growing at that rate.
Step 2What are the consistent values?

Keep the 80% payout and the growth falls to 3.1%: next year's dividend is Rs 12.37, divided by 11% minus 3.1%, about Rs 157. Or keep the 5% and ask what payout funds it: retention must be 5% over 15.5%, about 32%, so the payout falls to 68%. Next year's dividend is then Rs 15 x 1.05 x 0.677, about Rs 10.67, and the value is Rs 10.67 over 6%, about Rs 178.

Growth is not free: the solid line pays for it, the dashed line does notRs 150Rs 200Rs 250Model as given: Rs 2105% growth and an 80% payout5% funded, payout 68%: Rs 17880% payout funds only 3.1%: Rs 1571%3%5%7%Assumed dividend growth a year
Raising growth while keeping the Rs 12 dividend lifts value to Rs 210 at 5%, but growth funded by retained earnings gives about Rs 178 at 5% and Rs 157 at the 3.1% that an 80% payout supports; the two lines meet only where growth is fully funded.
CasePayoutGrowthNext dividend, RsValue, Rs
Colleague's model80%5.0%12.60210
Consistent, payout held80%3.1%12.37157
Consistent, growth held67.7%5.0%10.67178
The colleague's Rs 210 pays out 80% and grows 5% at once; holding either the payout or the growth consistent with a 15.5% return gives about Rs 157 or Rs 178.
Step 3Why is the funded 5% worth more than the 80% payout?

Because each retained rupee earns 15.5% while shareholders require 11%. Retaining profit creates value only when the return on it beats the cost of equity; here it does, so a lower payout with faster growth is worth more. If the regulator cut the allowed return to 11%, retention would add nothing and every payout would give the same value. That is why the allowed return, and how long the regulator holds it, is the number to research first.

Where candidates lose it

The trap is taking the payout and the growth rate from different places, the dividend from the annual report and the growth from a sector note, and plugging both into the formula. The result looks precise and counts the same profit twice.

The second miss is forgetting that a regulated utility cannot grow earnings without growing its asset base. Growth here is a funding question before it is a forecasting one.

What the interviewer asks next

  • The regulator cuts the allowed return to 13%. What is the value at an 80% payout?
  • Sarthal issues shares each year to fund 5% growth. How does that change the per share value?
  • Why is a single-stage dividend model reasonable for a utility and risky for a fast-growing company?

Company names and figures are illustrative.