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We often ask investors if companies can pay out dividends with earnings (payout ratio). Almost all of them say yes. But in reality, earnings are but an accounting measure. Dividends are paid in cash, and cash-flow analysis is the absolute core of dividend investing. 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 Paychex (PAYX), as well as its dividend under this unique but yet very straightforward framework.

Investment Highlights

• Paychex earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm's return on invested capital (excluding goodwill) to expand to 138.2% from 129.6% during the next two years.

• Paychex is a leader in the payroll, human resource, and benefits outsourcing industry. With a wide range of services - including payroll processing, retirement services, insurance, and a fully outsourced human resource solution - Paychex customizes its offering to the client's business.

• Paychex 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 25.1% in coming years, and the firm had no debt as of last quarter.

• The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.

• The firm sports a very nice dividend yield of 4.2%. We expect the firm to pay out about 82% of next year's earnings to shareholders as dividends. Though the payout ratio is high, the company boasts an excellent Valuentum Dividend Cushion score.

Investment Considerations

Return on Invested Capital

Paychex's Dividend

(click to enlarge)

Paychex's dividend yield is solid, offering roughly a 4.2% 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.

We think the safety of Paychex's dividend is excellent (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 Paychex, this score is 3.1, 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 Paychex'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 not the case for Paychex. We rate the firm's potential dividend growth as good as we'd demand at least a high single-digit future annual growth rate in the dividend to rate it excellent. Our estimate of Paychex's future annual dividend growth rate is roughly 4%.

And because capital preservation is also an important consideration for dividend growth investors, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Paychex's case, we currently think the shares are fairly valued, so the risk of capital loss is medium.

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

Source: Why Paychex's Dividend Is Solid, Despite High Payout Ratio