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When determining whether or not to buy an ownership interest in a certain company, there are a number of things that are often considered. Such things include the durability of the company's business model, the company's balance sheet, valuation, and historical earnings growth.

Another important consideration for many investors is the strength and sustainability of the dividend that the company pays out. Dividends are very important, as they accounted for about 42% of the total return of the S&P 500 from 1930 to 2012. The portfolios of many dividend-oriented investors are composed of dozens of dividend-paying stocks from a wide variety of sectors.

In today's article, I will delve into the consumer goods sector with a look at the dividends from two of the most prominent companies in that space. They are Procter & Gamble (NYSE:PG) and Clorox (NYSE:CLX). These are high-quality companies that produce everything from toothpaste to toilet paper to household cleaning products. I will examine the important aspects of each company's dividend, such as the dividend's history, whether or not the dividend can be covered by the company's earnings, and look for clues as to whether the company can continue paying out and growing their dividends going forward.

Many seasoned investors will look at the two companies above and say that this article is akin to determining whether Michael Jordan was a great basketball player. There may be some truth to that, but the main idea of this article is to provide a framework by which an investor can determine what company in a given sector has the strongest and most sustainable dividend in the event that the investor can only choose one from the group.

Dividend Yield

Usually, the first and most obvious consideration when analyzing a company's dividend is the dividend yield, which represents the percentage of your original investment that you will get back over the next 12 months, provided that the dividend does not change during that period. Let's compare the dividend yields of Procter & Gamble and Clorox.

Procter & Gamble3.1%
Clorox3.3%

Table 1: Dividend Yields Of Procter & Gamble and Clorox

Many investors will use a company's historical dividend yield, along with other metrics like historical P/E ratios, as a way to help determine if the stock is cheap or expensive. According to data from YCharts, the last time Proctor & Gamble's dividend yield was this high was in January 2013, one year ago. The same can be said when looking at the chart for Clorox.

When it comes to dividend yield, Clorox comes out the winner here, with its current 3.3% yield, along with the fact that the yield is at its highest point in about a year.

Dividend Growth

When evaluating the quality of a company's dividend, there is much more to it than just the yield. Sometimes, a company's stock may have a high yield due to poor fundamentals that have caused the price of the stock to fall relative to its dividend payout. These poor fundamentals could then lead to dividend cuts, which can then lead to a drop in your net worth.

Dividend growth is another very important factor. For one, dividend growth helps to preserve the purchasing power of your income stream by protecting it against inflation. Secondly, when a company increases its dividend, that is a sign of confidence by management when it comes to the company's fundamentals and future outlook. And third, growing dividends allow investors to share in the benefits of growing earnings. It should also be mentioned that dividend growth can supercharge an investor's yield on cost over the years. For instance, Warren Buffett and Berkshire Hathaway received a whopping 40% yield on cost in 2012 on shares of Coca-Cola that were purchased back in 1988. This is due to the dividends that grew almost fourteen-fold since the purchase.

Let's take a look at the dividend growth rates over the last 5 years of our two consumer goods stocks. The numbers in the table represent the average dividend growth rate over the last five years.

Procter & Gamble8.5%
Clorox9.1%

Table 2: Five-Year Dividend Growth Rates of Procter & Gamble and Clorox

It should be mentioned before I proceed further that both of these companies belong to the list of S&P 500 Dividend Aristocrats, an elite group of stocks that have increased their dividends for at least 25 consecutive years.

The dividend growth rates of both of these companies are impressive, easily outpacing inflation. Procter & Gamble has increased its dividend every year for the last 57 years. Clorox has increased its payout in 36 straight years.

These are impressive numbers and serve as testaments to the strong business models and long-term earnings growth of both of these companies, as well as the commitment of management to the shareholders.

If you were judging by just the dividend growth rate alone, then I'd say that Clorox gets the edge here, especially when considering that last year, Clorox increased its per-share payout by nearly 11%, while P&G increased its by just over 7%.

Dividend Payout Ratio

In many cases, it's not enough to only look at the dividend yield and the historical dividend growth rates of the stock in question. We need to make sure that the company is making enough money to support these dividend payments. This is where the dividend payout ratio comes into play. It represents the percentage of profits that the company has been allocating toward dividend payments, as opposed to being used for buying back stock or reinvesting into the company's operations. Generally speaking, the lower the payout ratio, the better. This is because lower payout ratios often indicate that there is plenty of room left for dividend increases in the future. Payout ratios that approach or even exceed 100% may indicate dividend freezes or cuts in the future.

Table 3 shows the trailing twelve-month payout ratios, as well as the average payout ratios over the last four years for Procter & Gamble and Clorox. These percentages are based on core earnings (non-GAAP).

CompanyTTM4-Year Average
Procter & Gamble57%54%
Clorox62%59%

Table 3: Dividend Payout Ratios of Procter & Gamble and Clorox

From looking at Table 3, none of the dividend payments of our two companies appear to be in any sort of danger. The payout ratios over the last twelve months are also in line with what we have seen over the last several years. While both of these payout ratios are very good, Procter & Gamble's is just a little bit lower.

But What About Free Cash Flow?

What we just did above was analyze the safety of the dividends relative to the company's earnings. However, earnings don't pay dividends, cash does. And, earnings often include a lot of non-cash items (like depreciation, amortization of patents, asset writedowns, actuarial gains on pension plans, etc.) that can distort one's perception as to the safety of a company's dividend. For this reason, a more accurate measure of determining a company's ability to pay its dividends is the payout ratio based on free cash flow. In other words, what percentage of actual cash that comes in over the course of a 12-month period gets paid out to shareholders?

Table 4 shows the free cash flow payout ratios of our two companies over the last 12 months, as well as the four-year averages. Note that free cash flow is calculated as operating cash flow minus capital expeditures.

CompanyTTM4-Year Average
Procter & Gamble71%64%
Clorox70%67%

Table 4: Free Cash Flow Payout Ratios of Procter & Gamble and Clorox

Table 4, like Table 3, shows that the current dividends of each company are well-supported. However, the payout ratios of these companies are a little bit elevated when compared to their 4-year averages. Right now, Clorox and P&G are both in the 70% range, which indicates that dividend growth may eventually moderate a bit unless we see increases in free cash flow. To summarize, none of these dividends are in any immediate danger.

These companies are too evenly matched to say which company's dividend is better in this category.

Other Tools To Predict Dividend Sustainability Going Forward

Many investors would stop at this point and vote yea or nay as to whether or not the dividends of the company in question are of good enough quality. And that's fair enough. However, what we have done so far is look at past dividend and cash flow data. Aside from what we have done so far, there are some other tools that we can employ in order to evaluate the ability of our two companies to pay out increasing dividends in the future.

Interest Coverage Ratio

The interest coverage ratio is simply the company's earnings before interest and taxes (EBIT) divided by the company's interest payments during the time period in question. This ratio shows whether a company can generate enough money to cover its interest payments, which must be made before any dividends can be paid out. The higher this ratio, the better. If the company is paying an exorbitant amount of interest relative to its pre-tax profits (a low interest coverage ratio), then that doesn't leave much room for dividends, which may be indicative of dividend cuts in the future. For this reason, dividend investors like to see high interest coverage ratios.

Table 5 shows the interest coverage ratios of Procter & Gamble and Clorox over the last 12 months.

Procter & Gamble21.7
Clorox9.03

Table 5: Interest Coverage Ratios of Procter & Gamble and Clorox

From Table 5, we see that both companies exhibit very healthy interest coverage ratios, showing that having to make interest payments has yet to interfere with either company's dividend. However, Procter & Gamble is superior to Clorox in this area, as the company's pre-tax earnings cover its interest payments almost 22 times!

Net Debt To Equity Ratio

The net debt to equity ratio is also very important. The amount of debt not only influences the amount of interest that must be paid, but also, the amount of debt that at some point will need to be repaid. Right now, a lot of companies are choosing to refinance their debt due to the presence of very low interest rates, as opposed to paying it off. However, if and when interest rates go higher, refinancing may be a less attractive option. As a result, extinguishing debt may have an effect on future dividend payments.

The net debt to equity ratio is calculated by dividing the net debt by the company's equity position. Net debt is simply the combination of short- and long-term debt minus the company's cash position. The lower this ratio, the better. Ratios typically below one are considered to be good. Table 6 shows the values of these ratios for our two companies.

Procter & Gamble0.39
Clorox13.9

Table 6: Net Debt To Equity Ratios of Procter & Gamble and Clorox

From Table 6, we see that Procter & Gamble is in very good shape in this area, and superior to Clorox in this regard. Clorox is a much smaller company, with a very small equity position.

Forecasted Earnings Per Share Growth

While dividend growth can be achieved to some extent through the expansion of the payout ratio, ultimately there must be free cash flow growth in order for there to be long-term dividend growth. And, free cash flow growth stems largely from earnings growth. In order to get a better idea as to whether the company can sustain growing dividends going forward, you may want to consider analyst projections for earnings growth over the next couple of years. Table 7 shows earnings per share growth estimates for each of our two companies from the analysts at S&P Capital IQ. The estimates are for fiscal 2014 and 2015.

Company20142015
Procter & Gamble11%9%
Clorox6%7%

Table 7: Forecasted Earnings Per Share Growth for Procter & Gamble and Clorox

The forecasted earnings per share growth for both companies look very respectable, but Procter & Gamble is expected to grow profits per share at a faster rate than Clorox over the next couple of years. Keep in mind that earnings per share growth can be fueled by stock buybacks as well as by cost cuts and revenue increases. When shares are repurchased, the same amount of money that's allocated for dividends will be divided among fewer shares, resulting in per-share dividend increases, without actually having spent more money on dividends.

Conclusion

In this article, we have analyzed the dividend strength of Procter & Gamble and Clorox by looking at a number of factors, including the dividend yield, dividend growth rates, payout ratios, interest coverage ratios, net debt to equity ratios, and analyst estimates for earnings per share growth. From looking at all of these items, it can be said that none of the dividends from these two companies appear to be in any kind of danger at this point in time.

When comparing the two companies, Clorox has a slightly higher dividend yield, and a slightly higher dividend growth rate over the last five years. However, Procter & Gamble has a much higher interest coverage ratio and a much lower net debt to equity ratio than Clorox, both of which show that the company's debt should not interfere with dividend payments in the near future.

In addition to a strong balance sheet, Procter & Gamble has better expected earnings per share growth than Clorox. While P&G's free cash flow payout ratio is in the 70% range, the company should still be able to deliver good dividend growth at its current rate if the expected earnings per share growth materializes.

The dividend of Clorox is not in any immediate danger and should continue to experience some growth, but when you have 6-7% forecasted earnings per share growth along with a free cash flow payout ratio of around 70%, a 9% dividend growth rate might not be as easy to sustain for a long period. In a situation like this, I would expect the dividend growth rate to eventually match the earnings per share growth rate.

So, if you had to choose between Procter & Gamble and Clorox based on dividend strength and sustainability alone, I think that Procter & Gamble has the upper hand.

For more information on how I analyze financial statements, please check out my website. It's a website I created just for fun, as well as to help fellow investors make intelligent financial decisions. Thanks for reading and I look forward to your comments.

Disclosure: I am long PG. 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.

Source: Who Has The Better Dividends: Procter & Gamble Or Clorox?