Dividend stocks aren't usually exciting investments. Income investors flock to them because of their stability and potential to build long-term wealth. One way dividend stocks accomplish the latter is by increasing their payouts, which they can do instead of investing their profits in acquisitions, capital expenditures, and stock buybacks, among other options.
In fact, several companies did just that earlier this year. According to the S&P Dow Jones Indices, dividend increases reached a record-high of $17.8 billion in the first quarter of 2014. During that period, 1,078 increases were reported, jumping 14% from a year ago and beating 1979's first-quarter record of 1069 increases.
However, companies can also reduce or halt dividends whenever they see fit, and 102 companies did just that in the first three months of the year. That's why income investors pay close attention to company financials when weighing different dividend stocks. Metrics such as profit margins and cash flow give investors a sense of a company's ability to maintain-and increase-its dividend over time.
We ran a screen on dividend stocks with this in mind. To begin, we constructed a group of dividend stocks that have plenty of cash on hand as illustrated by a cash/operating expense ratio of 4 or higher. This ratio takes the average of a company's last five quarters of operating expenses and compares it to the firm's short-term investments and cash on hand.
If the ratio stands at 1, the company has enough cash to cover its average expenses for the quarter without earning any income, as long as it hasn't increased operations (and added more expenses). If the ratio is under 1, the company doesn't have enough cash to cover its costs. A ratio of 4 or higher simply indicates that the company has more than enough cash to cover its expenses.
In addition to having enough margin to take care of short-term obligations, these cash-rich companies are also well-equipped to increase their dividends, pursue expansion opportunities, and/or make acquisitions.
Keeping with the cash theme, we then screened for undervalued stocks that are undervalued relative to their cash flows as shown by high ratios of levered free cash flow/enterprise value (LFCF/EV). Levered free cash flow is what remains of a company's free cash flow after it takes care of interest payments on outstanding debt. As the name suggests, enterprise value is a valuation metric. It's an alternative to standard market capitalization that's calculated by adding market cap., debt, minority interest, and preferred shares (excluding total cash and cash equivalents).
The LFCF/EV ratio shows investors the money a company has to grow its business and pay dividends. A ratio in excess of 10% is sometimes seen as a potential indicator of undervaluation.
We were left with three stocks on our list. Do you think these stocks will increase their dividends in the near future? Use this list as a starting point for your own analysis.
1. Cisco Systems, Inc. (CSCO, Kapitall snapshot): Designs, manufactures, and sells Internet protocol ((NYSE:IP))-based networking and other products related to the communications and information technology industry worldwide. Market cap at $118.12B, most recent closing price at $23.19.
Average quarterly operating expense over the last five quarters at $9460.8M, vs. most recent cash and short-term investments at $47065M, implies a Cash / Avg. Operating Expense ratio at 4.97.
Dividend yield at 3.28%.
Levered free cash flow at $9.61B vs. enterprise value at $89.65B (implies a LFCF/EV ratio at 10.72%).
Average quarterly operating expense over the last five quarters at $162.32M, vs. most recent cash and short-term investments at $768.6M, implies a Cash / Avg. Operating Expense ratio at 4.74.
Dividend yield at 2.64%.
Levered free cash flow at $254.25M vs. enterprise value at $1.62B (implies a LFCF/EV ratio at 15.69%).
Average quarterly operating expense over the last five quarters at $5.12M, vs. most recent cash and short-term investments at $83.35M, implies a Cash / Avg. Operating Expense ratio at 16.27.
Dividend yield at 8.09%.
Levered free cash flow at $46.14M vs. enterprise value at $339.53M (implies a LFCF/EV ratio at 13.59%).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: Kapitall is a team of analysts. This article was written by Mary-Lynn Cesar, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.