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We think the safety of Xerox's dividend is 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 (year). Therefore, 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.
As such, we've developed the forward-looking Valuentum Dividend Cushion. 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 Xerox, this score is 1.2 offering only a modest "cushion" and very little excess capacity for future dividend growth. Therefore, we rate its dividend safety as POOR.
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 unfortunately is not the case for Xerox. We think Xerox's potential dividend growth is VERY POOR, as the dividend has been stable the past several years and the company's finances reveal little capacity for future growth.
However, because capital preservation is also an important consideration for income investors, we assess the risk associated with the potential for capital loss (offering dividend investors a complete picture). In Xerox's case, we think the shares are undervalued, so the risk of capital loss is LOW. This is one of the few things income investors have going for them with a position in Xerox.
All things considered, we're more interested in Xerox's equity valuation than its dividend at this time. Its shares are cheap, but the dividend looks weak. As a result, we think it'd be a better fit for our Best Ideas list as opposed to the portfolio in our Dividend Growth Newsletter.