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Dividend growth investing is lots of fun, especially if you 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™. In this article, let's evaluate the investment merits of Automatic Data Processing (NASDAQ:ADP), as well as its dividend under this unique but yet very straightforward framework.

Investment Highlights

• Automatic Data Processing's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.

• Automatic Data Processing is one of the world's largest providers of business outsourcing solutions. The firm offers a wide range of easy-to-use human resource, payroll, tax and benefits administration solutions from a single source.

• Automatic Data Processing has an excellent combination of strong free cash flow generation and low financial leverage. We expect the firm's free cash flow margin to average about 15.3% in coming years. Total debt-to-EBITDA was 0 last year, while debt-to-book capitalization stood at 0.3%.

• ADP is one of only about four non-financial US companies rated AAA by S&P and Moody's. The company has minimal long-term obligations and has been paying dividends continuously since 1974.

• ADP boasts a large, recurring revenue base resulting in strong, consistent cash flow generation. An added plus is that the firm's business model has low capital requirements.

Investment Considerations

Return on Invested Capital

ADP's Dividend

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ADP's dividend yield is solid, offering roughly a 3% 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, ADP is about in line with what we prefer.

We think the safety of ADP'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.

For ADP, this score is 2.2, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow. We also use our dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter.

Now on to the potential growth of ADP'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. 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 ADP.

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 ADP's case, we currently think the shares are fairly valued, so the risk of capital loss is medium.

All things considered, ADP stands out to us as one of the better income plays on the market today.

Source: Why ADP's Dividend Makes The Cut