Dividend growth investing is lots of fun, especially if investors and financial advisors have a systematic methodology to determining which companies' dividends are safe and which ones' aren't. That is why we created a forward-looking assessment of dividend safety in our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™ (click here to learn about this tool). In this article, let's evaluate the investment merits of Wal-Mart (WMT), as well as its dividend under this unique but yet very straightforward framework.
Return on Invested Capital
Wal-Mart's dividend yield is about average, offering just above a 2% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Wal-Mart doesn't quite meet our criteria, but will it soon?
First of all, we think the safety of Wal-Mart's dividend is good (please see our definitions at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.
That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. Remember, earnings are an accounting measure, while cash is cash.
For Wal-Mart, this score is 1.4, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow. Companies that have scored below a 1 on this measure have shown increased risk as it relates to the dividend. We strongly encourage readers to take a look at the following article to get a feel for the tremendous benefits of the Valuentum Dividend Cushion: How To Shield Your Portfolio From Dividend Growth Blow Ups.
Now on to the potential growth of Wal-Mart's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years, the company has a nice growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is the case for Wal-Mart. The firm has a good cash flow profile to cover future dividends based on its capital structure. Looking at its historical dividend growth track record (view image above), one can see that a high-single-digit or low double digit pace of growth in coming years should be expected.
And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Wal-Mart's case, we currently think the shares are fairly valued, so the risk of capital loss medium. For a read on how we calculate the intrinsic value of Wal-Mart and hundreds of other companies in our coverage universe (click here), please view this article here. If we thought the shares were undervalued, the risk of capital loss would be low.
All things considered, we like the potential growth and safety of Wal-Mart's dividend, but the yield is a bit low. We'd wait for a dividend increase or a pullback in the shares to consider it in our income portfolio.