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We often ask investors if companies can pay out dividends with earnings (payout ratio). 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 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 Hewlett-Packard (NYSE:HPQ), as well as its dividend under this unique but yet very straightforward framework.

Hewlett-Packard's Investment Considerations

Evaluating Hewlett-Packard's Dividend

For starters, Hewlett-Packard's dividend yield is above average, offering a 2.2% 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 Hewlett-Packard doesn't quite fit the bill thus far. But let's dig into the safety and growth potential of its dividend to showcase the robustness of the process.

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Is Hewlett-Packard's Dividend Safe?

In the image above, the front page of our dividend report, we show our forecasts for Hewlett-Packard's dividend growth in the next few years (select the image above and view the bottom right). Though we're not forecasting significant growth in Hewlett-Packard's operations due to the riskiness of the turnaround, we think the safety of Hewlett-Packard's dividend is excellent (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 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 (cash from operations less capital expenditures) over the next five years and divides that sum (the numerator in image immediately below) by future expected cash dividends paid over the same time period (the denominator in image immediately below). 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 Hewlett-Packard, this score is 4.0, 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 (relatively easily, if we may add). This measure is among the best in our coverage universe, revealing significant excess expected cash-flow capacity (above and beyond our forecasts of dividend growth). To arrive at the Dividend Cushion score for Hewlett-Packard, dividend the numerator by the denominator in the image immediately below.

Derivation of the Dividend Cushion for Hewlett-Packard - $mil

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Source: Valuentum Securities

Derivation of Excess Free Cash Flow Available for Future Dividend Increases Above and Beyond our Future Forecasts, ex Buybacks - $mil

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Source: Valuentum Securities

Looking at the Dividend Cushion in a slightly different way in the image immediately above, one can see that most of Hewlett-Packard's excess free cash flow is driven by the strength of its operating cash flow. Capital expenditures and its net debt position make a dent, but its excess cash flow available for future dividend increases above and beyond expectations ('the blue box') is rather large. You'll notice the numerical value of the 'blue box' is the difference between the numerator and the denominator in the previous image above -- the excess cash above and beyond expected future dividends paid (excluding buybacks).

What About the Growth of Hewlett-Packard's Dividend?

Now on to the potential growth of Hewlett-Packard's dividend. As we mentioned above, we think the larger the "cushion" (the blue box) the larger capacity a firm has to raise the dividend. We love firms that pay high yields and have large blue boxes. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend (please go back to the front page of our dividend report above). 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 Hewlett-Packard.

Finally, because capital preservation is also an important consideration for all types of investors, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Hewlett-Packard's case, we currently think the shares are fairly valued, so the risk of capital loss medium. If we thought the shares were undervalued, the risk of capital loss would be low.

The Bottom Line

There is tremendous risk to Hewlett-Packard's operations as a result of the decline of the PC. However, the firm retains its cash-generating prowess, and capital expenditures won't be overwhelming. And while we don't forecast significant growth in the dividend in coming years, the company's Dividend Cushion score is among the best in our coverage universe (given the size of its yield). We're keeping a close eye on shares, though we reiterate the myriad risks of the firm's turnaround.

Source: Just How Safe Is Hewlett-Packard's Dividend?