If the SEC inquiry into Linn Energy's (LINE) non-GAAP cash-flow accounting has done anything, it has been to illustrate the importance of cash-flow analysis--not only with respect to valuation but also with respect to assessing the health of a firm's dividend. We've received a significant amount of interest in our Dividend Cushion measure since the inquiry, and we wanted to walk through the Dividend Cushion calculation in-depth for an example firm, Kimberly Clark (KMB), in this article.
Kimberly Clark's Investment Considerations
Kimberly-Clark is a Dividend Aristocrat meaning it has raised its dividend in each of the past 25+ years. The firm's dividend yield is above average, offering a 3.3% 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 Kimberly-Clark fits the criteria for inclusion into our portfolio thus far.
We think the safety of Kimberly-Clark'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, 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 dividends well into the future.
That has led us to develop the forward-looking Valuentum Dividend Cushion™, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (CFO less capex) 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 Kimberly-Clark, this score is 1.3, revealing that on its current path the firm should be able to cover its future dividends with net cash on hand and future free cash flow.
Please note that to arrive at the Dividend Cushion score, divide the numerator ($8,984 billion) by the denominator ($7,122 billion) in the first graph. A score of 1.3 is not great within our coverage universe and is barely in the 'good' category. The difference between the numerator and denominator is the firm's 'total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks'. The second chart below illustrates why Kimberly Clark has a 'slim' dividend cushion.
(click to enlarge)
Derivation of Kimberly Clark's Total Cumulative 5-year Forecasted Distributable Excess Cash after Dividends Paid, ex buybacks
As one can see from the chart immediately above, Kimberly Clark has a lot of dividends to pay out in the coming years relative to its free cash flow and after considering its balance sheet (the above does consider a 6% annual growth rate in the dividend, as shown on the front page of our dividend report). We prefer firms that have very large 'total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks' -- the blue bar above -- (and yields above 3%) in the portfolio of our Dividend Growth Newsletter. These are the strongest future dividend-growth companies on the market, in our view.
Now on to the potential growth of Kimberly-Clark'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 the case for Kimberly-Clark. After all, the company is a Dividend Aristocrat.
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 Kimberly-Clark's case, we currently think the shares are fairly valued, so the risk of capital loss is medium (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low. All things considered, Kimberly-Clark boasts a nice dividend yield, and the firm's Dividend Cushion score suggests decent (but not great) future dividend growth.
Note: Our assessment of Kimberly Clark's dividend has been borderline between good/poor in the past few years due to its Dividend Cushion consistently being so close to our cutoff of 1.25 for good (see below). The score is 1.26 at the time of this writing. Evaluating the numerical score can be a value add for readers -- in addition to considering our qualitative 'word' assessment.