If you're looking to buy a partial ownership stake in a publicly-traded company, then there are a number of things that you should consider before doing so. These things include the company's business model, historical earnings growth and corporate governance. Another thing that you may want to consider is the dividend.
Dividends are very important as they can provide some cushion for investors to the downside and can also signal confidence from management in the company's future. Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. Most of them prefer to diversify into many different sectors of the economy in order to spread out their risk.
Today, let's take a look at Johnson & Johnson (JNJ), a huge player in the healthcare sector of the economy. Let's see how the dividend of Johnson & Johnson stacks up in terms of strength and sustainability and what investors can expect going forward.
Considering that this article is about Johnson & Johnson, many seasoned investors out there will consider this analysis as having the same effect as saying that Michael Jordan was a great basketball player. However, this article does provide a framework by which an investor can determine the health of any company's dividend.
The first and most obvious consideration when evaluating a company's dividend is the dividend yield, which represents the percentage of your investment that you'll receive back over the next 12 months at current share prices and dividend payouts.
Johnson & Johnson currently yields 2.7%. This is the yield that is based on dividend payments that were made over the last 12 months. The company is expected to announce a dividend increase later this month. The dividend yield is currently at its lowest level over the past five years. Over the past five years, the dividend yield has ranged between 2.7% and 3.8%.
While the current yield is at its lowest level in some time, it is still respectable. This figure should rise as soon as the next dividend is announced.
When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation as well as to show confidence from management in the company's outlook.
Over the last five years, Johnson & Johnson has increased its dividend by an average of 7.5% each year. The company's most recent dividend increase was announced in April 2013 and was a roughly 8% hike. These dividend growth rates easily outpace inflation, which currently sits at around 1.6%.
Johnson & Johnson has increased its dividend every year for the last 51 years. There are very few companies who can claim such a long streak of sending money back to shareholders. Consider that fellow healthcare giant Pfizer has increased its dividend just 5 years in a row, after cutting it in half back in 2009. Merck has only increased its dividend three years in a row after freezing it from 2004 to 2011.
This long streak of dividend increases lands Johnson & Johnson on the list of S&P 500 Dividend Aristocrats, an elite group of companies that have increased their dividends for at least 25 years straight. The good yield and strong history of dividend increases illustrate the commitment of Johnson & Johnson when it comes to returning cash to shareholders.
Free cash flow payout ratio
While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better as they leave more room available for future dividend increases or other uses of the capital.
Free cash flow is the cash flow a company generates in its operations minus capital expenditures.
Over the last 12 months, Johnson & Johnson has paid out 53% of its free cash flow to shareholders in the form of dividend payments. This percentage is inline with what the company has done over the last four years. Its four-year average free cash flow payout ratio sits at just 50%. This is a very healthy payout ratio, which leaves plenty of room for future dividend increases, along with other value-creating activities.
From looking at the company's free cash flow payout ratio, it can be concluded that the dividend is in no danger at this point in time.
Interest Coverage Ratio
One of the ways in which we can determine whether or not a company will have trouble paying its dividend in the future is by looking at how much interest it has to pay every year. More money spent on interest means less money that is left for dividends. To determine the effect that debt has on a company's ability to pay its dividends and fund other activities, I calculate the interest coverage ratio. This ratio is calculated by dividing the company's earnings before interest and taxes by its interest payments over the year. You generally like to see this ratio at or above 2. If it's below this figure, then that may signal trouble ahead for the company in question.
Fortunately, this is not a problem at all for Johnson & Johnson. Its earnings before interest and taxes over 2013 of $16B covered its interest obligations a whopping 33 times. At this point, debt is not having an effect on the company's ability to pay its dividends.
Earnings per share growth forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth. This year, analysts expect Johnson & Johnson to increase its earnings per share by 5.4%, followed by a 7.9% increase in 2015. It should be mentioned that these projections are based on non-GAAP earnings.
Earnings per share growth in the high single-digit range should be more than enough to maintain the dividend going forward as well as support dividend increases in the future.
The stock of Johnson & Johnson currently has a reasonably attractive dividend yield. The company has shown a strong commitment to returning cash to shareholders through its 51-year streak of dividend increases. Its free cash flow payout ratios over the last several years show that the company's dividends have been well-supported by free cash flow, and that there is room for continued dividend growth. With a very healthy free cash flow payout ratio and expected mid to upper single-digit earnings-per-share growth, I see no reason why shareholders should not expect high single-digit dividend growth to continue for now. The company could even decide to expand its payout ratio a little bit for a double-digit dividend increase. We will see what the company decides to do very soon.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.