General Electric (GE) is a great American success story with a history of over a century, dating back to when Thomas Edison and JP Morgan founded the company to produce electricity. The company is the only remaining member of the original Dow Jones Industrial Average (DIA) and the dividend has always been a cornerstone for shareholders. During the financial crisis, GE famously cut its dividend on concerns regarding its ability to generate cash and earnings. Since then, however, GE is back to raising its dividend and is earning large profits again. The question for dividend investors is how safe is the dividend?
To find out, we'll take a look at a few metrics for the conglomerate to determine GE's dividend coverage and how much room it may have to raise the dividend in the future.
First up, GE's net income and dividends paid for the past six years can be seen below.
The relationship between earnings and dividends are often watched and quoted when evaluating a dividend stock. The relationship for GE can be seen above. According to GE's financials, it can comfortably cover its dividends with earnings.
The metric for this is called the payout ratio, which is simply the dividends paid divided by earnings.
When earnings started to tank during the financial crisis, we saw the payout ratio skyrocket to over 80%, only to fall to 40% on the back of rising earnings and a dividend cut. Now, the payout ratio is squarely where it was in 2007, at about 50%.
This would suggest that GE's dividend is quite safe and offers plenty of room for growth. However, I would argue that earnings are not the proper metric by which we should judge dividend safety. "Earnings" are nothing but an accounting metric that attempt to provide a full picture of the company's financial performance. It is great for doing so and for lowering the amount of taxes owed but it does nothing to tell us how much cash the company is generating. Indeed, you could have negative earnings with positive cash flows; Amazon (AMZN) was famous for this. Therefore, quoting earnings in relation to the dividends a company pays is comparing apples to oranges and should be ignored.
Now that we've established the irrelevance of the payout ratio, we can begin to examine GE's cash flows in relation to the dividend payments it makes. First, the measure of "cash flow" I'm using is simply adding the operating and investing cash flows for GE for each year. This gives a good picture of 1) the amount of money GE's assets produce in conducting its business and 2) the cost to acquire, dispose of and maintain those assets. I fully realize this is not a perfect metric of cash flows but nothing is and I feel like this one produces the best estimate of a company's ability to generate cash.
This graph depicts those two numbers for the past six years.
The huge negative investing cash flow numbers for 2007 and 2008 were driven primarily by a huge increase in GE Capital receivables and by acquisitions, respectively. After the financial crisis, we see a shift in strategy for GE, deciding to stash its cash instead of continuing to lever up. We see GE hoarding cash to the tune of over $68 billion each year in 2009 and 2010 but beginning to invest again in the past two years.
Now, we can compare the cash flow numbers we've just looked at to the net income figures we saw prior.
The major discrepancies in this data start in 2007 when GE reported $22 billion in net income but my measure of cash flow was negative $26 billion. However, we begin to see this moderate in 2008 and then when GE begins to hoard cash, the net income number becomes a fraction of cash flows. This is the trouble with using the payout ratio; it doesn't capture the company's ability to actually pay cash for its dividends.
Now, we can examine GE's dividend payments in relation to its cash flow numbers we just looked at.
What we see is that GE is producing an enormous amount of cash in its operating and investing activities that it can use for its financing activities. In this case, the financing activity we are referring to is the company's dividend payments.
As GE has begun to raise its dividend after the financial crisis, the dividend payments are dwarfed by the amount of cash the business is generating. For instance, in 2010, GE produced over $68 billion in cash from operating and investing activities and only paid $4.8 billion in dividends!
Finally, since we have established GE's net income, dividend and cash flow numbers, we can look at the way dividend payers are often measured, payout ratio, versus my measure, cash flow coverage. Using my method, we simply replace net income in the payout ratio formula with cash flow from investing activities plus cash flow from operating activities; the results are staggering.
The first note is obviously about 2007 when GE had a negative cash flow number as we saw earlier. Therefore, the CF coverage number is meaningless. However, with the exception of 2008 when cash flows almost equaled dividend payments, GE's ability to generate cash from running its business has been many times its dividend payment needs. You can see that the payout ratios (blue) are much larger than the CF coverage ratios (red) in the past four years. This depiction really drives home just how safe GE's dividend really is. In addition, it offers much more room to raise the dividend safely than the payout ratio might imply.
Given this information, I think it's safe to say that GE's dividend is among the safest I've ever seen. With CF coverage ratios in the teens, GE can raise its dividend to almost any amount it desires. However, I believe GE's management is still bound to the old way of thinking about dividends in reference to the payout ratio and will probably aim to keep the payout under 70% of earnings. Despite the fact that it's complete nonsense, millions of investors still rely on the payout ratio to judge dividend payers' safety. Therefore, GE management will likely cater to this crowd and keep the dividend payment low enough to make investors think the dividend is safe.
With the stock already yielding 3.3% and management's commitment to return capital to shareholders in a big way in the coming years, you can be sure that your dividend is safe. GE is producing enough cash each year to pay its financing needs many times over, including the dividend and debt retirements. However, management will be hesitant to raise the dividend too quickly because of old lines of thinking regarding the payout ratio and the desire to "milk" the dividend raises for all they are worth in terms of good publicity. In a few years' time, we could see GE's payout more than 50% higher than where it is today with no financing problems whatsoever.