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 biggest companies in that space. They are Procter & Gamble (NYSE:PG) and Colgate-Palmolive (NYSE:CL). These are both 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 mentioned 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.
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 the two companies.
Procter & Gamble
Table 1: Dividend Yields Of Procter & Gamble and Colgate-Palmolive
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. It was only about five months ago when Colgate-Palmolive's dividend yield was as high as it is now. When it comes to dividend yield, P&G clearly comes out the winner here, with its current 3.1% yield, along with the fact that the yield is at its highest point in about a year.
When evaluating the quality of a company's dividend, there is 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 & Gamble
Table 2: Five-Year Dividend Growth Rates of Procter & Gamble and Colgate-Palmolive
It should be mentioned before I proceed further that these companies both 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.
While the dividend growth rates of both of these companies are impressive, easily outpacing inflation, Colgate-Palmolive has the higher rate of dividend growth, north of 11%. Colgate-Palmolive has increased its dividend every year for the last 50 years. Procter & Gamble isn't too shabby in its own right, with a 5-year dividend growth rate of 8.5%. This company has increased its dividend for 57 years in a row.
These are both impressive numbers and serve as testaments to the strong business models and long-term earnings growth of these two companies. When looking at dividend growth over the last five years, Colgate-Palmolive wins out here.
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 Colgate-Palmolive. These percentages are based on core earnings (non-GAAP).
Procter & Gamble
Table 3: Dividend Payout Ratios of Procter & Gamble and Colgate-Palmolive
From looking at Table 3, neither 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 these payout ratios are very good, Colgate-Palmolive's ratio is just a little bit lower than P&G.
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 expenditures.
Procter & Gamble
Table 4: Free Cash Flow Payout Ratios of Procter & Gamble and Colgate-Palmolive
Table 4, like Table 3, shows that the current dividends of each company are well-supported. Right now, P&G is in the 70% range, which indicates that dividend growth may eventually moderate a bit unless we see increases in free cash flow. Colgate-Palmolive has a significantly lower free cash flow payout ratio, which shows a higher potential for dividend growth going forward.
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 four 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 Colgate-Palmolive over the last 12 months.
Procter & Gamble
Table 5: Interest Coverage Ratios of Procter & Gamble and Colgate-Palmolive
From Table 5, we see that Procter & Gamble's interest coverage ratio is exceptionally good, where it covered its interest payments almost 22 times. But, Colgate-Palmolive steals the show, as they didn't need to make any interest payments over the last 12 months, leaving more money for other purposes, such as you guessed it, dividends!
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 & Gamble
Table 6: Net Debt To Equity Ratios of Procter & Gamble and Colgate-Palmolive
From Table 6, we see that both Procter & Gamble wins out here, with a much lower net debt to equity ratio.
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 both companies from the analysts at S&P Capital IQ. The estimates are for fiscal 2014 and 2015.
Procter & Gamble
Table 7: Forecasted Earnings Per Share Growth for Procter & Gamble and Colgate-Palmolive
The forecasted earnings per share growth for both companies look very respectable, with Procter & Gamble getting slightly more favorable estimates than Colgate-Palmolive. 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.
In this article, we have analyzed the dividend strength of Procter & Gamble and Colgate-Palmolive 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.
Colgate-Palmolive has the lowest payout ratios, the highest dividend growth rate, as well as the highest interest coverage ratio. These items all indicate that investors in Colgate-Palmolive should continue to expect excellent dividend growth going forward. Procter & Gamble has a significantly higher yield and a better balance sheet. While the free cash flow payout ratio of P&G is a little bit elevated, good dividend growth should continue if the company's forecasted earnings growth materializes.
When it comes to which company's dividends are in better shape, I think it comes down to the investor's time horizon. While Colgate-Palmolive outshines Procter & Gamble on some of the metrics discussed above, the company's starting yield is so low that if you extended the five-year dividend growth rates of each company out indefinitely, it would take 15 years before an investment in Colgate-Palmolive would show a higher yield on cost, in spite of a better dividend growth rate. So, in my view, if you have more than 15 years ahead of you in your investment journey, then Colgate-Palmolive may make more sense. However, if you have a shorter time horizon than that, then Procter & Gamble might be more appropriate.
And, of course, before making a final investment decision, you need to consider other things such as valuation, geographic diversification, product diversification, strength of competition, etc.
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.