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We often ask investors if companies can pay out dividends with earnings. 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 by definition the absolute core of dividend investing. That is why we created a forward-looking assessment of dividend safety in our predictive dividend-cut indicator, the Dividend Cushion. In this article, let's evaluate the investment merits of Pepsi (PEP), as well as its dividend under this unique but yet very straightforward framework.

Pepsi's Investment Considerations

Pepsi's Return on Invested Capital

Pepsi's Dividend

(click to enlarge)

Pepsi's dividend yield is above average, offering a 2.8% annual payout at recent price levels (the yield on S&P firms is about 2%). We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio. So Pepsi doesn't quite fit the bill for inclusion into our Dividend Growth portfolio. But let's evaluate the firm's dividend safety and dividend growth. The results may surprise you.

For starters, we think the safety of PepsiCo's dividend is...dare we say...poor (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. 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 of 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 Pepsi, this score is 1.1, revealing that on its current path the firm can barely cover its future dividends with net cash on hand and future free cash flow. This isn't much of a cushion.

Now on to the potential growth of Pepsi'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. To do so, 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 PepsiCo. We have them rated as having neutral growth potential--it's recent pace of growth offsets the limited cushion it currently has.

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 Pepsi's case, we currently think the shares are fairly valued, so the risk of capital loss is medium. If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, we're not calling for a dividend cut at Pepsi, but its poor Dividend Cushion score doesn't leave much room for future growth in it.

Source: Pepsi's Dividends Are Not Paid With Earnings