Are You Using The Right Payout Ratio?

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 |  Includes: APD, RDS.A, RDS.B
by: Cash Flow Investor

The payout ratio is one of the most important metrics that dividend growth investors consider when evaluating potential investments. The payout ratio is traditionally calculated as the dividend divided by net income, and it serves as a quick check on a company's ability to comfortably cover its dividend payment. A lower payout ratio (say, 30-40%) suggests that a company has ample room to raise its dividend faster than its growth in earnings per share, while a payout ratio in the middle range (50-60%) suggests that the company can adequately cover its dividend. Payout ratios approaching - or even exceeding - 100% are red flags, alerting investors that a dividend cut is likely unless the company finds a new way to increase its revenue.

The traditional method of calculating the dividend payout ratio can be useful, but it only indirectly answers the question that a dividend investor ultimately cares about: after the company pays its necessary maintenance costs, will there be enough cash left over to cover the dividend? In my own investment research, I have sought the answer to this question by taking a slightly different approach to calculating the payout ratio.

Look at Free Cash Flow, Not Net Income

The payout ratio I prefer - and one that has saved me from a few investing mistakes - is the dividend divided by free cash flow, rather than net income. For a variety of accounting-related reasons, net income can mask the true economics of a business. Free cash flow is a truer measure of the cash that a company actually has available after having paid its necessary maintenance expenses - it is free cash flow that is the available pot of money out of which dividends may be sustainably paid. In order for a company to pay a dividend in excess of its free cash flow, it must either deplete existing assets (by drawing down existing cash or selling off assets) or obtain additional financing (by incurring new debt or issuing new shares). None of these options are particularly appealing, since they weaken the existing business to some degree, and none are sustainable in the long term. If a company is paying dividends in excess of its free cash flow, then it is not a dividend that I would consider to be "well covered," regardless of what the net income payout ratio indicates.

Example: Royal Dutch Shell

Using this alternative payout ratio has saved me from a few situations in which the traditional payout ratio indicated that the dividend was covered - only for the company to later declare a dividend freeze or cut when the free cash flow ran out. One specific example is Royal Dutch Shell (NYSE:RDS.B), the global oil behemoth.

In early 2010, following the global sell-off in stocks, I considered picking up shares of Royal Dutch Shell. In the prior fiscal year, Royal Dutch Shell had paid $10.7 billion in dividends on a net income of $12.5 billion, for a payout ratio of 86%: not great, but still suggesting that the dividend was being covered. But then I looked at the dividend as a percent of free cash flow:

(Amounts in millions)

Year

Dividend

Free Cash Flow

FCF Payout Ratio

2005

12,500

14,209

88%

2006

8,142

8,774

93%

2007

9,001

9,885

91%

2008

9,841

8,853

111%

2009

10,717

(5,028)

N/A

Click to enlarge

Source: Morningstar.

This tells a slightly different story: where the net income payout ratio indicated that the dividend was still being covered by current income, the free cash flow payout ratio suggested that the situation was more dire, and that the company was not able to pay its dividend in a sustainable fashion.

After reviewing the free cash flow numbers above, I passed on Royal Dutch Shell as an investment at that time. Shortly thereafter, the company announced that it was freezing its dividend, and it did not raise its dividend again for two years (and even then, it was only a 2.4% raise).

Air Products and Chemicals - Warning Signs?

Since then, I've seen the lesson of Royal Dutch Shell play out for other companies. One company I've considered from time to time is Air Products and Chemicals (NYSE:APD), which shows up on the screens of many dividend growth investors. Looking at the payout ratio as traditionally calculated (i.e., dividend divided by net income), there seems to be sufficient coverage of the dividend:

(Amounts in millions)

Year

Dividend

Net Income

Traditional Payout Ratio

2008

349

910

41%

2009

373

631

55%

2010

399

1,055

38%

2011

457

1,262

36%

2012

573

1,193

43%

Average

43%

Click to enlarge

Source: APD Annual Reports 2012 and 2009.

But a closer look at the Statement of Cash Flows reveals that APD doesn't generate enough cash to cover its dividend from current operations:

(Amounts in millions)

Year

Dividend

Free Cash Flow

FCF Payout Ratio

2008

349

595

59%

2009

373

144

259%

2010

399

492

81%

2011

457

402

114%

2012

573

244

235%

Average

150%

Click to enlarge

Source: Morningstar.

APD has paid dividends since 1954, and they have been increasing their dividend at an admirable growth rate (with an increase of nearly 11% being the most recent). But I haven't been able to get around the fact that, to pay their dividend, APD must (1) draw down cash, (2) sell assets, (3) incur additional debt or (4) sell additional shares (diluting the equity base). A quick check of APD's financial statements confirms that, since 2010, the cash on the balance sheet has modestly increased and the share count has declined slightly - but long term debt has gone from $3.66 billion to $4.58 billion, which is approximately enough to fund the last two years of dividend payments. Generally speaking, I prefer to be paid out of a company's current earnings (which can be repeated and sustained), rather than relying on the company's ability to obtain additional debt on favorable terms.

Conclusion

Calculating the payout ratio by using free cash flow instead of net income may be a more useful analytical tool for dividend growth investors. While in many instances one can expect the results to be similar, looking directly at free cash flow gets to the heart of what dividend growth investors care about: does the company generate enough spare cash to comfortably cover the dividend? In my own experience, there have been a few surprises when the two approaches have diverged, and relying on the free cash flow calculation has helped me avoid a few potholes along the way.

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.