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Johnson & Johnson's (NYSE:JNJ) status as a dividend aristocrat is something the company and its shareholders hold sacred. JNJ has been able to increase its payouts for decades, but if you look at the payout ratio for JNJ, that is, the amount of earnings the company pays to shareholders as dividends, it may suggest at first glance that JNJ's streak of increased dividends may be at risk at some point in the near future. This would be correct if JNJ was paying its dividend out of earnings. However, it isn't. In fact, no company pays its dividend out of GAAP earnings, or net income. The reason is net income contains all sorts of non-cash items that are useful for informing investors and reducing tax bills but do little in terms of valuing the operating assets of a company. Companies do, however, pay their dividends out of cash flows. After all, JNJ isn't transferring "earnings" to its shareholders; rather, it is transferring actual cash. I would argue, therefore, that JNJ's headline "payout ratio" is virtually meaningless and should be ignored. The metric we should be paying attention to is JNJ's payout as a ratio of operating cash flows. This is the actual cash the business generates and this is how JNJ pays its shareholders.

To illustrate this point, we'll take a look at a few metrics that illustrate just how safe JNJ's dividend really is. First, we'll take a look at JNJ's annual operating cash flows versus its dividend payments to shareholders, in millions of dollars.

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What we see here is striking; JNJ has steadily increased its dividend payments every year, as we already knew, but its operating cash flows, the money the business earns by conducting business, dwarf the substantial dividend payments. For example, last year, JNJ's operating cash flows were greater than $15 billion but dividend payments totaled to less than half that amount. We see similar stories for the other years on this chart.

Next, we can calculate JNJ's headline payout ratio that is often quoted for dividend safety and our measure of dividends as a percentage of operating cash flows.

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The main point to notice here is that as JNJ's dividend has risen in recent years, so has its payout ratio. While in the 40% range during the financial crisis, JNJ's payout ratio has ballooned to over 60% as of last year. However, our measure of dividends as a percentage of cash flows shows that JNJ's situation is not nearly that dire. In fact, even though it too has risen since the financial crisis, this method shows that JNJ is only paying out just over 40% of its operating cash flows as dividends.

Also, just in case you were wondering if JNJ's investing activities are eating up a huge amount of the cash the company's assets are producing, the short answer is "no."

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We can see that JNJ's investing cash flows are a small portion of its operating cash flows, with last year's investing cash flows making up about $5 billion worth of expenditures versus over triple that amount as operating cash flows.

The point is that while JNJ's oft-quoted payout ratio is rising and nearing the danger zone for some investors approaching two-thirds of earnings, the idea that JNJ's dividend increases may begin to slow or even stop (!) is far-fetched at this point. JNJ still has ample room to increase its payout and still be operating well within the constraints of the cash the company's assets produce each year. In fact, in order for JNJ's operating cash flow payout ratio to hit the company's current earnings payout ratio of 61%, JNJ could increase its dividend by $2.77 billion annually, or a 41% increase in the dividend. I'm not suggesting the company will do this right away of course but it lends some credibility to the idea that JNJ is as rock solid as ever, even if the earnings payout ratio is climbing a bit.

If you are a bit impatient waiting for those dividend increases or would just like some extra income and downside protection, you can look to sell the July 85 call for $0.77 against your shares. This trade would allow some room for upside from the current price of $82 and still offer some downside protection and income. If you are a bit more cautious, the July 82.50 call can be sold for a hefty $1.74, offering a 2% nominal yield in about three months and substantial downside protection in exchange for losing some upside potential. With the stock trading near all-time highs, however, maybe selling some premium isn't such a bad thing. You can always buy your shares back before the ex-div date if you like.

Source: Johnson & Johnson: How Safe Is The Dividend?