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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. In a recent study, S&P 500 stocks that initiated dividends or grew them over time registered roughly a 9.6% annualized return since 1972 (through 2010), while stocks that did not pay out dividends or cut them performed poorly over the same time period.

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Such analysis is difficult to ignore, and we believe investors may be well-rewarded in future periods by finding the best dividend-growth stocks out there. As such, we've developed a rigorous dividend investment methodology that uncovers firms that not only have the safest dividends but also ones that are poised to grow them long into the future. (We highlight our best dividend picks here.)

To develop our dividend methodology, first of all, we scoured our stock universe for companies that have cut their dividends in the past to uncover the major drivers behind the dividend cut. The major reasons had to do with preserving cash in the midst of a secular or cyclical downturn in demand for their products/services, or when faced with excessive leverage (how much debt it held on its balance sheet).

The Importance of Forward-Looking Dividend Analysis

Armed with this knowledge, we developed the forward-looking Valuentum Dividend Cushion™, which is a ratio that gauges the safety of a dividend over time.

Most dividend analysis that we’ve seen out there is backward-looking – meaning it rests on what the firm has done in the past. Although analyzing historical trends is important, we think assessing what may happen in the future is even more important. The S&P 500 Dividend Aristocrat List, or a grouping of firms that have raised their dividends for the past 25 years, is a great example why backward-looking analysis can be painful.

In fact, one only has to look over the past few years to see the removal of such big names from the Dividend Aristocrat List, like General Electric (NYSE:GE) and Pfizer (NYSE:PFE), to understand that backward-looking analysis is hardly worth your time. After all, you’re investing for the future, so the future is all you should care about. We want to find the stocks that will increase their dividends for 25 years into the future, not use a rear-view mirror to build a portfolio of names that may already be past their prime dividend growth years.

The dividend cushion measures just how safe the dividend is in the future. It considers the firm’s net cash on its balance sheet and adds that to its forecast future free cash flows and divides that sum by the firm’s future expected dividend payments. At its core, it tells investors whether the company has enough cash to pay out its dividends in the future, while considering its debt load. If a firm has a score above 1, it can cover its dividend, but if it falls below 1, trouble may be on the horizon.

In fact, the our Dividend Cushion™ would have caught every dividend cut made by a non-financial operating firm that we have in our database, except for one, Marriott (NASDAQ:MAR). But interestingly, our cushion indicated that Marriott should have never cut its dividend, and sure enough, two years after the company did so, it raised it to levels that were higher than before.

Here are the results of our study. A score below 1 indicates the dividend may be in trouble. Also, our backtesting methodology is as follows: {[Net Cash (year prior to dividend cut) + forecast free cash flows (CFO-capex) over the next five years, using actual where appropriate] / the pre-cut dividend rate in year prior to dividend cut extrapolated five years forward}. We are completely transparent. The score shown in the table below is the measure in the year before the firm cut its dividend, so the Dividend Cushio represents a predictive indicator:

At the very least, using the our process can help you avoid firms that are at risk of cutting their dividends in the future.

How Safe Are Some of the Dividends of Some Well-Known Stocks?

Here’s a glimpse of the current score for a sample set of firms in our coverage universe. The scores below reflect each company's net balance sheet impact + our forecast of its future free cash flows during the next five years, with that sum then divided by forecasted dividend payments over the next five years. We've chosen firms that score above one to demonstrate how our measure differentiates between companies with strong dividend coverage and companies with weak dividend coverage (remember the scores above). We view the dividends of the firms below as relatively safe:

But What about the Growth of a Firm’s Dividend?

It takes time to accumulate wealth through dividends, so dividend growth investing requires a long-term perspective. As a result, we assess the long-term future growth potential of a firm’s dividend. And we don’t just take management’s word for what they will do with their dividend. Instead, we dive into the financial statements and make our own forecasts of the future to see if what they’re saying is actually achievable. We use our dividend cushion as a way to judge the capacity for management to raise its dividend – how much cushion it has – and we couple that assessment with the firm’s dividend track record, or management’s willingness to raise the dividend.

In many cases, we may have a different view of a firm’s dividend growth potential than what may be widely held in the investment community. That’s fine by us, as our dividend-growth investment horizon is often longer than others. We want to make sure that the firm has the capacity and willingness to increase the dividend years into the future and will not be weighed down by an excessive debt load or cyclical or secular problems in fundamental demand for their products/services.

Plus, we don’t use fancy language for what we think of its future growth. We scale our assessment in an easily-interpreted fashion: Excellent, Good, Poor, Very Poor.

In this article, let's evaluate the dividend of Clorox (NYSE:CLX):

First of all, Clorox's dividend yield is high at about 3.7%, so we view the name as a nice income generator. But we think the safety of its dividend is relatively poor. We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges (read: hiccups in operations), which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter or year. As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.

Therefore, we've developed the forward-looking Valuentum Dividend Cushion. As outlined above, the measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends.

As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future.

For Clorox, this score is 0.9, meaning the firm does not have a cushion or capacity for future dividend growth. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies.

Now on to growth. As we mentioned above, we think the larger the cushion, the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years and the company has a nice growth rate, its future potential dividend growth is excellent, which is not the case for Clorox. We rate the firm's future dividend growth potential as very poor, which is a function of its weak dividend cushion score.

However, we don't just stop there. By employing a matrix, one can see above that Clorox doesn't have an attractive dividend in our eyes--the cross section of its poor safety and very poor future potential growth scores. And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Clorox's case, we think the shares are fairly valued, so the risk of capital loss is medium. If we thought Clorox was undervalued, we'd consider the risk to be low. (To view a narrated presentation on our valuation process, please click here.)

All things considered, we're not tempted by Clorox's dividend at all. We think there are better income options out there at this point.

Our full report on Clorox can be found here.

Source: Clorox's Dividend Is Not So Safe