In part 1 of the series on dividend investing tools we looked at dividend yield. But whilst the lure of a juicy dividend yield can prove to be as irresistibly sweet as a Siren’s song, we must first check that the waters ahead look safe. If the company is unable to afford to maintain the payout as well as invest for future growth then the attractions of such shares will prove to be illusory. We will therefore proceed to examine some of the typical safety factors involved in assessing whether a dividend looks sustainable and likely to grow.
In this part we will look at dividend cover and free cash flow.
Firstly, we need to compare the amount of the dividend to the profits the company is making. Whilst a company may be able to pay a dividend on a temporary basis without making sufficient profit, for example out of cash reserves, in the long run this is not a sustainable position.
The comparison of profits to dividends is measured by a ratio called dividend cover which is simply calculated as follows:
Dividend Cover = Earnings Per Share ÷ Dividend Per Share
Earnings per share measures the amount of profits attributable to the shareholders of the company after all costs have been deducted including interest, tax, and minority interests. The higher the dividend cover is, the safer we can view the dividend as there is greater scope to carry on paying the dividend even if there is a downturn in profits. Clearly, we are looking as a minimum for profits to exceed the dividend and so the dividend cover should be greater than 1, but a safer range for dividend shares is usually in the range of 1.5 to 2.5 times; and any more than that will usually mean the dividend yield is on the low side. For comparison, at the moment the dividend cover for the FTSE100 as a whole is 2.37 times. When deciding whether the level of cover is adequate it will depend on the type of business: for example the lower end of the range only for large, stable businesses and the upper end of the range for smaller or cyclical businesses.
Note that the dividend cover can also be driven by a company’s actual dividend policy. In the company’s annual report, results announcements or in the dividend section of their corporate website, they will sometimes give a target dividend cover. This can also be expressed as a payout ratio which is the proportion of earnings which are paid out as dividends and therefore it is simply the inverse of dividend cover. So if for example the dividend cover is 2 the payout ratio is 1/2 or 50%.
For example on AstraZeneca’s website it states their dividend policy as follows:
The Board has adopted a progressive dividend policy, intending to maintain or grow the dividend each year but, recognising that some earnings fluctuations are to be expected, the annual dividend will reflect the Board’s view of the earnings prospects over the entirety of the investment cycle. Dividend cover may therefore vary during the period but the target is for an average dividend cover of 2 times (i.e. a payout ratio of 50 per cent), based on reported earning (before restructuring costs).”
Note the part in brackets at the end stating “before restructuring costs” which brings us on to another consideration when it comes to earnings per share (EPS). A company will often give a Basic EPS figure and an Adjusted EPS figure; with the latter being the company’s view of the “underlying” performance of the business after stripping out any one-off, or “exceptional”, costs or profits. It is this adjusted EPS which is commonly used for the dividend cover figure, but it is important to also understand what adjustments have been made if there is a large difference between the two figures. Unfortunately, sometimes this underlying EPS can be abused by companies wanting to make their results look better and so beware of the same adjustments being made over and over again. If the basic EPS is persistently a lot lower than adjusted EPS it can be a warning sign that the latter is potentially overstated.
Lastly, we should note the relationship between the P/E ratio, dividend cover and dividend yield. The inverse of the P/E ratio is called the earnings yield which is the dividend cover multiplied by the yield:
Earnings yield = 1/PE Ratio = EPS/Price = EPS/DPS x DPS/Price = Dividend Cover x Dividend Yield
The lower the PE ratio, the higher the earnings yield, and so the lower PE ratio stocks are likely to be able to provide both a high dividend yield and high dividend cover.
Free cash flow
Earnings are important, but we should also remember that a company requires cash to pay dividends and for a variety of reasons a company’s cash flow can vastly differ from its profits, such as:
- The requirement for capital expenditure. The income statement only reflects a charge for the depreciation of already-purchased fixed assets which is spread over the estimated life of the asset. The cash flow of a company will however depend more on the timing of when the purchases are made (and can therefore be “lumpier”) and also reflect the need to make substantially more immediate investment than the income statement is currently recognising in depreciation.
- Changes in “working capital” i.e. debtors, stocks and creditors. For example, the profit on a sale is recognised at the point in time a sale is made although the company might not be paid for a while so an amount receivable is recorded in the balance sheet. During the course of the year if the company’s debtors increase then the company’s cash flow worsens by the amount of the increase. The same goes for any increases in the level of a company’s stocks, or if creditors decrease.
Cash flow is also considered important as a check that the earnings of a company are ‘real’. Occasionally in the past companies have managed to manipulate their earnings by abusing accounting standards or best practice (such as the Enron scandal) or simply because sometimes earnings can rely on judgements and estimates. Cash however is fact and much harder to manipulate.
As a result it is a good idea, in addition to earnings cover, to calculate free cash flow cover by using the cash flow statement within the company’s accounts. This is something which many private investors overlook and it can be very illuminating to understand cash flow movements and how a company is spending its cash rather than just concentrating on earnings. Whilst there are various definitions of free cash flow, depending on the job for which it is required, my preferred definition from the point of view of dividend sustainability is:
Free cash flow = cash flow before acquisitions, dividend payments and changes in debt and equity
= net cash from operating activities* less capital expenditure
*net cash from operating activities is after working capital movements, tax and interest. Occasionally however, companies disclose interest elsewhere in the cash flow statement so ensure this is taken into account.
Once we have calculated free cash flow we can then compare it to EPS by dividing it by the weighted average number of shares in issue during the year in order to obtain the free cash flow per share. Then as we did above with EPS we can easily calculate free cash flow cover by dividing by the dividend per share.
A simple example: WH Smith
Suppose we wanted to calculate free cash flow cover for WH Smith which was commented on in a previous article. We need to start off by finding the company’s cash flow statement in their recent results announcement and then pull out the figures we require in order to calculate free cash flow. The below extract marks the required figures with a green arrow:
The indicated figures amount to a total free cash flow for WH Smith for the year ended 31 August 2012 of £78m. We can already see that free cash flow covers the dividends paid in the year of £31m two and a half times which shows that the dividend paid was very well covered, so much so that the company spent an even greater amount of surplus cash flow on share buy backs (i.e. “purchase of own shares for cancellation”) as referred to in the article linked to above.
We can also easily convert this figure to a per share number by dividing by the weighted average number of shares in issue in the year, as is done to calculate EPS. By looking at note 7 to the results announcement we can see that in order to calculate the Basic EPS of 64.6p they have divided earnings of £84m by the weighted average number of shares of 130m. So in the same way by dividing the free cash flow of £78m by this latter number we arrive at a free cash flow per share of 60.0p. We can therefore summarise the dividend cover for WH Smith for 2012 as follows:
|Total dividend per share||26.9p|
|Basic earnings per share||64.6p|
|Dividend cover||2.4 times|
|Free cash flow per share||60.0p|
|Free cash flow cover||2.2 times|
From the above we can conclude that WH Smith’s dividend is well covered by both earnings and cash flow which supports a view that its dividend is sustainable based on current trading. This is however only looking at a single year and with equity analysis in general it is always a good idea to look at a few years’ history.
A couple of final remarks to make on this example:
1) Although it is not required by accounting standards, sometimes companies disclose their own calculation of free cash flow in their results and you will see from the first page of the results that WH Smith do this. They have however arrived at a figure of £91m which is £13m higher than the result above since they have excluded contributions made to their pension deficit which is an arguable point. Given that companies will make their own tweaks to the calculation such as excluding exceptional cash flows, I would always recommend you carry out your own analysis from first principles to ensure consistency.
2) In the headlines and earnings per share note they disclose a “Diluted EPS” of 62.7p i.e. slightly lower than the Basic EPS of 64.6p. This is common across most companies: it is a calculation using a higher number of shares to take into account the reduction in earnings per share arising from share options likely to be exercised. It would therefore be more prudent to calculate cover based on the diluted numbers although the difference is usually small (otherwise there may be a concern over the level of share options being granted!).
The above example above for WH Smith was a very simple one since a lot of cash flow statements for large, more complex businesses will have many more lines of disclosure to sift through and for the beginner it may seem a little overwhelming at first. But stay with it; it will eventually become second nature and is a worthwhile exercise in my opinion: the cash flow statement is an important source of information for investors in addition to the income statement and balance sheet.
Understanding free cash flow
The version of free cash flow referred to above excludes movements in debt and equity since dividend investors, from a sustainability point of view, would rather see the dividends being paid from the operations of the business as opposed to a reliance on borrowings or issuing more shares.
In addition, we have excluded the cost of acquiring other businesses. Whilst this can be a necessary part of growth for some companies with limited organic growth opportunities, it is nevertheless discretionary in nature and so it is unlikely that a dividend would be cut by the directors in favour of splashing out on an acquisition (or at least one would hope so).
It should be noted however that we have included all capital expenditure and working capital movements within the above definition and therefore we are allowing for reinvestment needs for organic growth in the company’s existing business. As a result those companies which are growing more rapidly will generally look worse from a free cash flow perspective, although my preference is still to see the dividend at least covered after catering for such needs. But even with a slower growth rate, this is one of the reasons why we may expect free cash flow on average to be less than earnings; and so free cash flow cover in excess of 1.3 times is probably a fair target, but the higher the better of course.
But it is not uncommon to see the dividend uncovered by free cash flow even though a reasonable earnings cover exists. This doesn’t always mean the company is unsuitable as an investment, especially if there is identifiable investment in value enhancing growth. For this reason we sometimes see a modification to free cash flow to only take into account “maintenance capital expenditure”, namely only that required to maintain the company’s existing operational capacity. An example might be a retailer whose cash flow looks poor as a result of capital expenditure spent opening new stores: if this amount is clearly identifiable then it would be deducted to arrive only at the capital expenditure for maintaining and renewing its existing stores. One of the issues with this adjustment is that companies do not have to disclose a breakdown of their capital expenditure in such a way; so you would normally either estimate it or find something to help within the directors’ commentary on the figures.
In fact, the above revised definition is similar to what Warren Buffett calls “owner earnings” as referred to in his 1986 letter to shareholders. He also said that in most businesses GAAP earnings (i.e. as reported in the income statement) will overstate owner earnings and in some businesses the overstatement would be substantial. Again, this supports the view that even without investment in growth free cash flow is likely to be a little less than earnings and this is often seen to be the case with more capital intensive businesses where the cost of replacing fixed assets may be higher than has been reflected in the historic depreciation charge. A particularly unhappy position would be a company struggling to maintain its competitive position with the constant need to reinvest in its asset base without seeing the benefit of revenue growth. Conversely, we will usually see better cash flow from the high return on capital businesses which require less capital relative to their growth rate: something which we will look at in more detail in a future article.
So to summarise, dividend cover in terms of earnings is an important consideration in the sustainability of dividend payments, but we also need to take this one step further and ensure the company is generating sufficient free cash flow from which to pay the dividend.
Image courtesy of David Castillo Dominici / FreeDigitalPhotos.net