Wednesday, 5 November 2014

Cashflow as an Indicator for Sustainable Dividends

I am primarily an investor for income. A large proportion of that income comes from the dividends from my equity portfolio.

When I am weighing up a share for possible addition to my watch list or to purchase, I will usually look at a number of factors -

  • dividend yield which is basically the current years dividend as a percentage of the current share price; 
  • the dividend cover, which is the earnings per share divided by the dividend per share - preferably 2x or above; 
  • the dividend payout ratio, essentially dividend per share divided by earnings and expressed as a percentage - preferably somewhere between 35% and 65%;
  • I also look at free cashflow cover (FCF) i.e the cash left over after profits have been reinvested in the business. It is from this spare cash flow that dividends are paid, not its operating earnings.

It is important for me to ensure that the shares I choose to invest in can provide me with a growing income from dividends for many years to come. Of course, there are no guarantees when it comes to the stock market - the problems with Tesco over the past year or two for example, but I believe the more research I carry out prior to purchase, the better chances I will have of making a sound investment decision. This sounds simple, however when looking at a company’s dividend the most important aspect for me to consider is whether it is sustainable over the longer term.

Accounting rules allow companies some discretion regarding the earnings numbers that they release. This can lead to distorted views of how successful a company is and struggling firms can appear as though they are producing stronger results.

Cashflows do not allow the same wriggle-room that earnings offer. If a company has more cash going out than they have coming in, this will be obvious in the cashflow statement. Dividends are paid in cash, so a company that has paid a consistent dividend is likely to have a steady stream of cash coming in. Therefore, these companies possibly have solid business models and are expected to navigate a downturn in the economic cycle more easily. Monitoring a firm’s cash flows year on year will give me a good indication of whether or not the dividend is sustainable. If firms have negative cash flows, but are paying a dividend anyway, I believe they should be treated with caution.

Calculating Free Cashflow Cover

This will require a look at the latest results. Scroll down to the Cash Flow Statement - usually after the Balance Sheet.

Free cash flow cover = (Cash generated from Operations minus Property, Plant & Equipment or Capital Expenditures) / Dividends Paid

A minimum cover of around 1.4x to 1.5x  is usually what I look for to provide a reasonable margin of safety. The higher the cover for free cash flow, the more sustainable the current dividend in my book.

If the FCF is below 1.0x or even negative, then I consider the dividend is possibly under threat - the company may be able to maintain dividend payments for a short period by extra borrowing but this would not be sustainable in the longer term.

It is also worthwhile checking back over a couple more years to assess the level of FCF cover and to see if the cover is rising or falling - one years figure can be misleading.

A Couple of Examples from my Portfolio

Earlier this year, retailer Next reported its final results - here’s a link via company website. You will find the Cashflow Statement (Unaudited) some ¾ down the report.. Cash generated from operations (before tax) is £766.8m, payments on capital expenditure to acquire PP&E is £102.6m and therefore deducting this from cash generated leaves £664.2m.

The dividends paid is £164.8m. Therefore Free Cashflow Cover is 664.2/164.8 = 4.03x - I would regard this level as very safe.

Another of my holdings is media company BSkyB which reported full year results in July - link via Investegate. Cash generated from operations was £1,769m (before tax), payments for capital expenditure on PP&E was £241 so again, deducting this from cash generated leaves a figure of £1,528m.

The dividends paid for the year were £485. Therefore FCF Cover is 1528/485 = 3.15x - slightly less than Next but again, a very comfortable level of cover.

Payout Ratio

Another important factor to consider regarding dividend sustainability is the payout ratio; while high dividends are important, a lower payout ratio - under 50% - tends to be a positive indicator. If a company is paying out nearly all of its earnings in dividends, this may be a sign that the dividend is not sustainable. Also, if the payout ratio is increasing over time, this might indicate that earnings growth is not keeping up with dividend growth, and the dividend is not sustainable. Companies with strong cash flows and low payout ratios have room to grow the dividend, and also tend to exhibit positive price appreciation. The ideal for me is a ratio somewhere between 40% - 65%.

Shares that offer a more sustainable dividend often fall into so called defensive sectors such as utilities and telecoms (did someone say supermarkets?), as these companies are not as negatively affected by a market downturn. When the economy retreats, as it has in recent years, consumers will limit their discretionary spending, so firms that sell non-essential products should see some decrease in sales. This can make sustaining a dividend particularly difficult for these companies. Firms in areas such as telecoms and utilities sell products and services that consumers have little option but to purchase. As a result it is easier for them to sustain a dividend, and suggests that they will make it through a recession more easily.

Besides finding the right balance between dividend yield and dividend growth, companies with favourable cashflows are therefore the companies that I try to target as core holdings for my equity income portfolio.

Take it easy - enjoy the wonderful autumn colours!

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