In the aftermath of Coca-Cola's (NYSE:KO) second-quarter results, we wanted to dig into why we expect the beverage behemoth to continue raising its dividend well into the future. Though it may be easy to point to a number of qualitative factors, we at Valuentum like to get into the gory cash flow details. After all, making projections about the future based on qualitative factors is what investing is all about. Let's dig in.
Coca-Cola's Investment Considerations
Before we get started, please take a look at the image above and more specifically the lower right corner of the image where we forecast Coca-Cola's future dividends. Note that we expect the firm's annual dividend payment to reach $1.61 per share by the end of fiscal 2016, which implies a very nice growth rate.
Coca-Cola is a Dividend Aristocrat--meaning it has raised its dividend in each of the past 25 years (50+ in Coca-Cola's case). Perhaps needless to say, management is very shareholder friendly. The firm's dividend yield is above the average of S&P 500 companies (~2%), offering a 2.7% annual payout at recent price levels. Though we prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio, Coca-Cola is right on the cusp for consideration.
The Safety of Coca-Cola's Dividend
Derivation of the Dividend Cushion for Coca-Cola - $ mil
We think the safety of Coca-Cola'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 via the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand (on its balance sheet) plus its expected future free cash flows over the next five years and divides that sum (see numerator in image above) by future expected dividends (including growth) over the same time period (see denominator in image above). 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 Coca-Cola, this score is 1.7, revealing that on its current path the firm has a relatively large cushion to cover its future dividends (and our expected growth rate in the firm's future dividends). To arrive at the Dividend Cushion for Coca-Cola, divide the numerator by the denominator in the image above.
We can also look at the Dividend Cushion in a slightly different way by subtracting the denominator from the numerator. This result is the excess cash that the firm can allocate toward increased dividend payments above and beyond our future dividend growth projections (high single-digits). The larger the 'blue box' (the cushion), the more excess cash that can be allocated to future dividend increases. We think the best dividend-payers on the market today have a combination of high dividend yields and a large 'blue box' (cushion), which has embedded within it a relatively large dividend growth rate.
Derivation of Excess Cash That Can Be Applied to Dividend Payments Above and Beyond Current Growth Projections - $ mil
Please note that from the graphic above, it is easy to see just how much of a cash cow Coca-Cola is. The firm doesn't have to plow that much back into the business via capital expenditures, its net cash/debt position is negligible, and the biggest use of cash is actually to pay out dividends. The cushion ('blue box') to pay out more dividends above and beyond our expectations is quite large.
Assessing the Growth Prospects of Coca-Cola's Dividend
Now on to the potential growth of Coca-Cola'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 Coca-Cola. After all, the firm 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 Coca-Cola'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, Coca-Cola has raised its dividend in each of the past 50+ years. Valuation and technical considerations aside, it is one of the stronger dividend growth ideas on the market today.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.