Distribution of profits in two stock markets

This is a tale of the difference in the distribution of profits in two stock markets and relates to the following budget proposal that has attracted considerable controversy in the business sector.

“If the gross dividend distributed by any company is less than 25% of its distributable profits for that year, the company will be required to pay additional tax amounting to 15% of the excess of one third of the distributable profits over the profits already distributed, if any. The distributable profits for any year would be the after-tax profits for that year reduced by the excess of the cost incurred in that year, on the acquisition of land or other capital assets over the depreciation charged thereon”.

The Colombo Stock Exchange Price Earnings Ratio (PER) on Friday, November 24 was 14.33 and the Dividend Yield (DY) was 2.1. This amounts to a dividend distribution of 30.1%. The equity market details for a selection of well-known companies listed in the London Stock Exchange show that the average Price Earnings Ratio of these companies was 19.1 while the Dividend Yield was 2.9%. This amounts to dividend distribution of 55.3%. What is the explanation for the dividend distribution of these well-known companies listed in the London Stock Exchange being nearly 84% higher than the Colombo Stock Exchange?

As the Managing Director of the CIC Paints (Pvt) Limited, a subsidiary of Imperial Chemical Industries (ICI) of UK, I was invited to a two day training programme conducted for the CEO’s of ICI companies in Asia. It was conducted by an eminent professor from the London Business School, who is a financial consultant to the Boards of Directors of leading companies in UK. He pointed out that the major shareholders of leading companies are pension funds, unit trusts and insurance companies. They are dependant on steady dividends of the companies in which they have invested to look after the interests of the pensioners and their investors. They use their shareholder power to demand the creation of shareholder value by these companies.

They insist on about 50 percent of the earnings being distributed as dividends. They demand that the earnings reinvested earn a return that is commensurate with the risk as measured by the Beta factor over what they can earn from fixed income instruments. Hence, all capital investments are carefully evaluated to ensure that they provide the expected minimum returns. In addition, these institutional investors welcome opportunities to invest in new ventures and acquisitions that provide them attractive returns. Hence, there is no need for companies to retain a major portion of the distributable profits as in Sri Lanka.

The emoluments of the Chief Executives and the senior management are linked to the creation of share value and act as a powerful incentive to maximise shareholder value.

In Sri Lanka, there are no significant investments by the provident funds, unit trusts, savings banks or insurance companies in our stock market, to influence the companies to increase their dividends.

The poor dividend yields, market uncertainties and government regulations that insist on a high percentage being invested in treasury bonds, do not provide the framework for these institutional investors to increase their investment in equities. In the absence of institutional investors, Sri Lankan companies retain a high percentage of their distributable profits. This is justified as long as the money invested offers good shareholder value. A good example of a company of this nature is the Distilleries Company where the share price has appreciated 134% in one year.

The tax on companies who distribute less than 25% of their distributable profits is justified as long as the company rate of tax is 35%. Unfortunately, in the case of banks the effective tax is nearly 60%. This is a result of the 20 percent tax on profits before tax and salaries euphemistically called value added tax. The previous government introduced this unorthodox tax, apparently to mop up excessive profits arising because of temporary market conditions. The present government has not been able to revert to normal taxation because of the need to control the budget deficit. This tax is inhibiting the growth of the economy because of high interest rates required to lend profitably and needs to be reviewed at the next budget. In addition, there is a need for banks to retain adequate funds to maintain the capital adequacy ratios required to continue the growth. Hence, there is a strong case for exemption of banks from this tax.

With the increasing interest by retail investors from all parts of the island in investing in the stock market to get a positive return under inflationary conditions, the government has introduced a number of measures in the 2007 Budget to create a share owning society. These measures have not received the encouragement they deserve from the private sector.