History has revealed that the best-performing stocks during the previous decades have been those that shelled out ever-increasing cash to shareholders in the form of dividends. This makes a lot of sense, as the strongest dividend growers are often the strongest generators of increasing cash flow. Coca-Cola (NYSE:KO) is one such gem. Let's evaluate the dividend growth prospects of the soft-drink giant in this article.
But let's first start with framing this analysis for readers. Most dividend assessments tend to be backward-looking--meaning the evaluation rests more on what the company has done in the past: how long it has raised its dividend, for example. Don't misunderstand. We think analyzing historical trends is important, but investors should understand that for a cash-rich, growing company to raise its dividend by a reasonable amount in each of the past 20, 30 or more years isn't much to write home about.
Imagine, for example, giving your grandson a $1 for his age on each consecutive birthday. Though you'll effectively be raising his "dividend" each year, the payout isn't necessarily tied to your income stream, nor is it very taxing on your lifestyle (even if he lives to 100 years or older). In a similar manner, a dividend payment is not explicitly tied to a firm's earnings stream nor is it very taxing on a firm to raise its dividend each year. For one, firms with substantial earnings don't have to pay a dividend, and companies can report declining earnings and still raise their dividend in the same earnings release.
Over the long haul, earnings growth will have to support dividend growth, but in instances where the payout ratio is low, earnings don't necessarily have to expand for the company to raise its dividend for years and years. A company can double its payout ratio by raising its dividend for 50 consecutive years, for example, but the payout ratio at the end of the period could still only be 50% of earnings at the beginning of the 50-year period. Fascinating, no?
With all of this said, it becomes obvious that assessing the future capacity of growth of the dividend is really what matters most for dividend growth investors. After all, dividend growth investors are investing for the next 5, 10, 20 years, not the past 5, 10, 20. And they want their dividends to increase by a material amount. This forward-looking perspective that assesses the potential magnitude of future dividend growth is all the difference in the world. That is why we created a forward-looking assessment of dividend growth through the innovative the Valuentum Dividend Cushion methodology.
For those that may not be familiar with our boutique research firm, we generate a discounted cash-flow analysis for all firms in our coverage. We use these future forecasts for free cash flow (cash flow from operations less capital expenditures) and expected cash dividend payments and consider the company's net cash position to evaluate just how much capacity a firm has to keep raising its dividends long into the future.
For those math-oriented folks, the Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based and driven from items taken directly off the financial statements. Let's take a look at the dividend report on Coca-Cola to understand how all of this comes together.
Image Source: Valuentum
Coca-Cola's dividend yield is nice, offering ~3% annual payout at current price levels (~$41 per share). We prefer yields of 3% or greater in the Dividend Growth portfolio, so Coca-Cola is certainly on our watch list for consideration. In case you missed it in the image above, the bottom right of the table reveals our expectations of Coca-Cola's future pace of dividend growth (~8%-9% per annum). We make forecasts for every company in our coverage universe. Here's how we assign dividend growth rates on the basis of a firm's qualitative considerations:
Dividend Growth Potential
Excellent: 8% or higher
Very Poor: 0%-2%
Let's now dig into Coca-Cola's qualitative ratings for dividend safety, dividend growth potential and risk of capital loss.
Dividend Safety / Cushion GOOD / 1.7
We assess the safety of a firm's dividend by adding the company's net cash to our forecast of its free cash flows over the next five years. We then divide that sum by the total expected dividends over the next five years. This process results in our Dividend Cushion
ratio. A Dividend Cushion above 1 indicates a firm can cover its future dividends with net cash on hand and future free cash flow, while a score below 1 signals trouble may be on the horizon. And by extension, the greater the score, the safer the dividend, as excess cash can be used to offset any unexpected earnings shortfall. Coca-Cola scores a 1.7 on our Dividend Cushion, which is GOOD.
Dividend Growth Potential EXCELLENT
We judge the future potential growth of the dividend by evaluating the capacity for future increases, as measured by the Dividend Cushion, and management's willingness to consistently raise the dividend, as measured by the firm's dividend track record. Coca-Cola registers an EXCELLENT rating on our scale, and we think the firm's annual dividend will be $1.69 per share within the next several years (by the end of 2018). This forecast is driven by our expectations of the dividend to expand at an ~8%-9% compound annual growth rate.
Risk of Capital Loss - MEDIUM
We assess the risk of capital loss based on our analysis of a firm's intrinsic value at this point in time. If the stock is undervalued (based on our DCF process), we think the risk of failing to recoup one's original capital investment (ex dividends) is relatively LOW. If the stock is fairly valued (it falls within our fair value estimate range), we think the likelihood of losing capital (ex dividends) is MEDIUM. If the stock is trading above our estimate of its intrinsic value, we think the likelihood of losing at least a portion of one's
original investment (ex dividends) is HIGH. Coca-Cola registers a score of MEDIUM on our scale. Though we generally prefer firms that are underpriced, or have a LOW risk of capital loss, in this market environment, very few dividend growth firms have this quality.
Coca-Cola's Investment Highlights
- Coca-Cola's business quality (an evaluation of our ValueCreation™ and ValueRisk™ ratings) ranks among the best of the firms in our coverage universe. The firm has been generating economic value for shareholders with relatively stable operating results for the past few years, a combination we view very positively.
- Coca-Cola is the world's largest beverage company. The firm owns and markets four of the world's top five nonalcoholic sparkling beverage brands: Coca-Cola, Diet Coke, Fanta and Sprite. The firm has seventeen $1 billion brands and more on the way.
- We live in a thirsty world. Since 2010, the nonalcoholic ready-to-drink (NARTD) beverage category has advanced at a nice mid-single-digit annual pace. NARTD retail value has increased by $135 billion during this time and is expected to grow more than $300 billion by 2020. Coca-Cola is very wellpositioned to capture incremental growth driven by growing middle-classes across the world.
- The company boasts a number of competitive advantages: its brands, financial strength, distribution system, global reach, and a deep executive bench. Though the strength of Coca-Cola's competitive position is undeniable, we don't expect the 'cola wars' with Pepsi to subside anytime soon, nor do we think social pressures against sugary colas will wane.
- Investors should be cognizant of the generosity embedded in Coca-Cola's fair value estimate, stemming from a low discount rate and elevated growth in the out-years in our discounted cash-flow valuation model. We value Coca-Cola's shares at $35 each at the time of this writing, so its valuation is not a steal, though we note that very few firms with such strong fundaments ever are.
All-in, Coca-Cola has raised its dividend in each of the past 50+ years, and the soft-drink giant looks poised to continue that trend. The firm has a solid Economic Castle, and we don't think its ability to generate economic profit will change anytime soon. Though we don't hold the company in the Dividend Growth portfolio, as shares aren't a huge bargain as it relates to valuation, the firm's dividend growth potential remains as strong as ever.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.