Any master architect will tell you the the key to a quality structure is its foundation. Solid buildings have firm foundations. The more solid the foundation, the less likely the building will suffer damage from storms, earthquakes, or settling of the earth. In much the same way, the foundation of solid Dividend Growth Stocks are their financials. Here's what to look for when evaluating a dividend stock's financials:
Changes in a shareholder’s equity are a result of earnings, dividends paid, treasury stock purchased, stock options exercised and amount of stock issued. If shares outstanding aren’t increasing, and equity is rising then the business is generating sufficient earnings to cover dividends and share repurchases. Increasing the value of the company by running the business well is a sign of a healthy company.
Many companies sell stock to raise cash. The important question is, what is the company going to do with the cash? Will the cash be used for an acquisition or “general corporate purposes?” The latter is code for 'the business is not generating enough cash to stay afloat on its own.' I am leery of a company that consistently grows its shares outstanding in the absence of major acquisitions.
Free Cash Flow
Free cash flow focuses on cash generated by the business. It excludes asset sales and cash generated from financing, such as debt issuances and stock sales. To have cash available for dividends a company must have cash left over after paying the operating expenses and normal capital expenditures. For this reason I look for companies that have had positive free cash flow for the last 10 years and a free cash flow payout of less than 60%.
Debt to Total Capital Ratio
Dividends that are paid out of free cash flow must compete with the other needs of the business such as interest and debt payments. Lower debt and interest requirements make available more cash for dividend payments. Like shares outstanding, I am leery of a company that consistently issues debt in the absence of major acquisitions. For this metric, I look for companies that have a debt to total capital ratio of 45% or less.
Cash On The Balance Sheet
Some businesses are so good at what they do, and have so few opportunities for reinvestment, they tend to build up large cash balances. Companies like this that also pay a cash dividend provide an additional layer of comfort that the dividend is sustainable.
Stocks With Quality Financials:
Amounts in millions
- The Coca-Cola Company (NYSE:KO) | Yield: 2.8%
Equity: 2001 $11,366.0, 2006 16,920.0, 2010 31,317.0
Shares: 2001 2,487, 2006 2,344, 2010 2,322
FCF Payout: 55%
Debt to Total Capital: 43%
Cash on Balance Sheet: $8,517
Equity: 2001 $2,345.0, 2006 2,550.0, 2010 2,803.0
Shares: 2001 173, 2006 170, 2010 158
FCF Payout: 43%
Debt to Total Capital: 15%
Cash on Balance Sheet: $530
Equity: 2001 $35,830.0, 2006 36,752.0, 2010 49,430.0
Shares: 2001 6,712, 2006 5,766, 2010 5,578
FCF Payout: 31%
Debt to Total Capital: 4%
Cash on Balance Sheet: $5,498
AFLAC Inc. (NYSE:AFL) | Yield: 2.1%
Equity: 2001 $5,425.0, 2006 8,341.0, 2010 11,056.0
Shares: 2001 522, 2006 495, 2010 471
FCF Payout: 8%
Debt to Total Capital: 23%
Cash on Balance Sheet: $2,121
Equity: 2001 $24,233.0, 2006 39,318.0, 2010 57,291.0
Shares: 2001 3,080, 2006 2,963, 2010 2,754
FCF Payout: 41%
Debt to Total Capital: 23%
Cash on Balance Sheet: $19,355
Equity: 2001 $35,102.0, 2006 61,573.0, 2010 71,655.0
Shares: 2001 4,484, 2006 4,168, 2010 3,562
FCF Payout: 30%
Debt to Total Capital: 41%
Cash on Balance Sheet: $7,395
Equity: 2001 $5,510.0, 2006 9,383.0, 2010 14,629.0
Shares: 2001 1,209, 2006 1,207, 2010 1,102
FCF Payout: 25%
Debt to Total Capital: 39%
Cash on Balance Sheet: $1,283
A solid foundation is just the beginning. Selecting quality dividend stocks with sustainable dividends requires the investor to not only look back at the financials, but also look forward to determine if the business can continue to thrive going forward. To succeed as a dividend investor, you must find companies that can sustain and grow dividends by focusing on their ability to generate cash. You can fake earnings, but you can’t fake cash.
Disclosure: Long KO, GPC, INTC, JNJ, WMT, MDT. See a list of all my income holdings here.