History has revealed that the best-performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. Unfortunately for the individual investor, most dividend analysis that we've seen out there is backward-looking - meaning it rests on what the company has done in the past: how long it has raised its dividend, etc.
Although analyzing historical trends is certainly important, we also think assessing what may happen in the future is even more important. That is why we created a forward-looking assessment of dividend safety through our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™. We use our future forecasts for free cash flow (cash flow from operations less capital expenditures) and expected dividends and consider the company's net cash position to make sure that each company is able to pay out such dividend obligations long into the future. In this article, let's evaluate the dividend growth prospects of Hewlett-Packard (NYSE:HPQ).
Image Source: Valuentum
First of all, Hewlett-Packard's dividend yield is solid, offering nearly a 2% annual payout at recent price levels. Though we prefer yields above 3% and don't include firms with yields below 2% in our dividend portfolio, for a company like Hewlett-Packard, we're keeping a close eye on the firm. And here's why.
For starters, we think the safety of Hewlett-Packard's dividend is EXCELLENT. 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 make earnings an even less-than-predictable measure of the safety of the dividend in any given year. 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). Management teams are focused on the long-term relationship between earnings/cash flow growth and dividend payments. 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 a forward-looking measure called the Valuentum Dividend Cushion™. The measure is a ratio that sums the excess cash a company has on hand (cash and cash equivalents less total debt) plus its expected future free cash flows (cash flow from operations less capital expenditures) 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 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 3.7, offering both a nice "cushion" and revealing excess capacity for future dividend growth (above and beyond our existing dividend growth projections--please view bottom right table in the image above).
Now on to the potential growth of Hewlett-Packard'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. As such, 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.
However, we don't just stop there -- we make it easy for the individual investor to view the health of a dividend with a simple view of a matrix. Also in the image above, one can see that Hewlett-Packard has a very solid dividend--the cross section of its EXCELLENT safety and EXCELLENT future potential growth scores (view matrix). Though our valuation process is documented elsewhere, we include our assessment of the risk associated with the potential for capital loss in the image (offering dividend growth investors a robust and straightforward picture). In Hewlett-Packard's case, we think the shares are fairly valued, so the risk of capital loss is MEDIUM. If we thought Hewlett-Packard was undervalued, we'd consider the risk to be LOW.
All things considered, Hewlett-Packard scores well on the Dividend Cushion, but the firm's turnaround could make the dividend more risky than our projections suggest. We'd still be cautious due to long-term fundamental concerns, even though the company has robust safety and growth measures, which are based on financial projections.