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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 biggest companies in that space. They are Clorox (NYSE:CLX) and Kimberly-Clark (NYSE:KMB). These are both high-quality companies that produce everything from 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 the two companies.

Clorox

3.4%

Kimberly-Clark

3.1%

Table 1: Dividend Yields Of Clorox and Kimberly-Clark

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 Clorox's dividend yield was this high was in January 2013, one year ago. The dividend yield of Kimberly-Clark has remained about the same for the last three months.

When it comes to dividend yield, Clorox comes out the winner here, with its current 3.4% 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 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.

Clorox

9.1%

Kimberly-Clark

6.9%

Table 2: Five-Year Dividend Growth Rates of Clorox and Kimberly-Clark

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, Clorox has the higher rate of dividend growth. Clorox has increased its dividend every year for the last 36 years. While Kimberly-Clark has the lower five-year dividend growth rate, these numbers are skewed a bit by 2009, when they only raised the dividend by 3.4%. Last year, Kimberly-Clark increased its dividend by 9.5%, while Clorox increased its dividend by almost 11%. Kimberly-Clark has increased its dividends for 41 years in a row.

These are impressive numbers and serve as testaments to the strong business models and long-term earnings growth of these two companies. When it comes to dividend growth over the last five years, Clorox comes out the winner 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 Clorox and Kimberly-Clark. These percentages are based on core earnings (non-GAAP).

Company

TTM

4-Year Average

Clorox

62%

59%

Kimberly-Clark

53%

55%

Table 3: Dividend Payout Ratios of Clorox and Kimberly-Clark

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, Kimberly-Clark has the lowest.

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 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.

Company

TTM

4-Year Average

Clorox

70%

67%

Kimberly-Clark

58%

63%

Table 4: Free Cash Flow Payout Ratios of Clorox and Kimberly-Clark

Table 4, like Table 3, shows that the current dividends of each company are well-supported. Right now, Clorox is in the 70% range, which while inline with its 4-year average, indicates that dividend growth may eventually moderate a bit unless we see increases in free cash flow. Kimberly-Clark, on the other hand, has a more conservative free cash flow payout ratio that indicates the potential for stronger dividend growth in the future.

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 Clorox and Kimberly-Clark over the last 12 months.

Clorox

9.03

Kimberly-Clark

11.8

Table 5: Interest Coverage Ratios of Clorox and Kimberly-Clark

From Table 5, we see that both companies exhibit very healthy interest coverage ratios. At this point in time, interest obligations should not interfere with dividend payments for either company. Kimberly-Clark here gets the edge due to covering its interest payments almost 12 times with pre-tax profits.

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.

Clorox

13.9

Kimberly-Clark

0.92

Table 6: Net Debt To Equity Ratios of Clorox and Kimberly-Clark

From Table 6, we see that Kimberly-Clark is in much better shape than Clorox when it comes to balance sheet leverage.

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.

Company

2014

2015

Clorox

6%

7%

Kimberly-Clark

11%

8%

Table 7: Forecasted Earnings Per Share Growth for Clorox and Kimberly-Clark

The forecasted earnings per share growth for both companies look very respectable, with Kimberly-Clark getting more favorable estimates. 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 Clorox and Kimberly-Clark 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.

Kimberly-Clark has the lowest free cash flow payout ratio, the highest interest coverage ratio, the healthier balance sheet, and stronger earnings per share growth estimates. These items all indicate that investors in Kimberly-Clark should continue to expect excellent dividend growth going forward.

While Clorox is currently the highest-yielding stock of the two, and has had a very good dividend growth rate over the last several years, the company's free cash flow payout ratio is elevated some, and its expected earnings per share growth rate lags that of Kimberly-Clark. There is no danger at all to its dividend at this point in time, 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.

For these reasons, I conclude that Kimberly-Clark's dividends are stronger and have more growth potential going forward.

For more information on how I analyze financial statements, please check out my website at this link. 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.

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

2. Who Has The Stronger Dividends: Procter & Gamble Or Kimberly-Clark?

Source: Whose Dividends Should Grow More Over Time: Clorox Or Kimberly-Clark?