As part of a continuous effort to systematically identify the most attractive dividend names in the S&P 500, we will periodically post insights from our dividend strategy in Seeking Alpha. In this initial article our team would like to introduce the backbone of our fund's dividend strategy and why this month's best dividend payer is Western Union (NYSE:WU). In the future our plan is to use the valuation model we built to expose different insights in the world of dividend investing.
A systematic approach of finding undervalued dividend names
Our approach starts with the premise that the two most important factors used to identify good dividend payers are the sustainability of future cash flows and the dividend yield of a given company. Dividend investors' primary focus should be to find firms that have both a relatively high sustainability and dividend yield. Firms with high cash flow sustainability are much more likely to increase dividends going forward, thus providing a boost to future dividend yields. Stocks that provide high sustainability and yield are more likely to outperform the market. Furthermore, we have notice that throughout the web a significant amount of dividend investors focus their attention on historical dividend growth. In our view, simply looking at historical dividend growth is somewhat irrelevant as a factor in a systematic dividend strategy. Therefore we decided to exclude historical dividend growth as a factor in our analysis.
How do we estimate the sustainability of a company cash flows?
In order estimate the dividend sustainability of a company we use the weighted average of the percentile rank of three dividend related metrics - 1. fixed charge coverage, 2. EBITDA dividend payout ratio, and 3. the sustainable growth rate. Each one of the these three metrics describes in a different perspective the capital flexibility of a firm.
- The fixed charge coverage allows a comparison of the relative amount of capital left for firms after fixed charges (ie. capital expenditure, rental expense, SG&A expenses). A firm with a large fixed charge ratio tends to be less financially constrained, thus likely being able to raise dividends in the future.
- The EBITDA dividend payout ratio is a measure of the quantity of dividend a company pays relative to its operating cash flows. Firms with higher payout ratios usually have less flexibility to raise dividends in the future. We prefer to use the EBITDA payout ratio rather than the net income payout ratio because EBITDA better represents the true operational performance of a company.
- Finally the sustainable growth rate estimates the total potential asset growth of a firm if it were to plow back all its available free cash flow. Firms with higher sustainable growth have more capital to deploy in the future. One major form of capital deployment is dividend increases.
- Fixed Charge Coverage Ratio = (Operating Cash Flow + Fixed Charge) / Fixed Charge
- EBITDA Dividend Payout Ratio = Total Dividends / EBITDA
- Sustainable Growth Rate = (EBITDA - Fixed Charges) / Asset Base
Below are the S&P firms that displayed the highest dividend sustainability in January 2016. While several of these firms do not pay a significant dividend yet, they are likely to increase their yield going forward. Gilead (NASDAQ:GILD) is a great example of that. Although the company only pays a 1.9% div yield today, investors should expect to see that increase in the future.
Top 10 dividend names by the sustainability factor
|Name||Market Capitalization (NYSEARCA:BIL) [USD]||Fixed Charge Coverage Percentile Rank||Dividends / EBITDA Percentile Rank||Sustainable Growth Rate Percentile Rank||Sustainability Factor Score|
|Gilead Sciences Inc||130.3||98%||86%||100%||95%|
|Acuity Brands Inc||9.0||96%||97%||90%||94%|
|Thermo Fisher Scientific Inc||53.8||91%||96%||94%||94%|
Source: Produced by the author
Measuring the dividend yield factor
Differently than measuring dividend sustainability, the yield factor calculation is a lot more straight forward. In this case we simply take the percentile rank of the current dividend yield and the three-year median yield for normalization purposes. Below is a list of the top ten dividend yield names. Note that with the exception of Blackstone (NYSE:BX) no other company in the list has a sustainability score of above 20%. As we shall see next this is not surprising, firms paying "too good to be true" yields like AT&T (NYSE:T) and Kinder Morgan (NYSE:KMI) have a very high probability of cutting dividend funding in the future unless they are able to access capital markets.
Top 10 dividend names by the yield factor
|Name||Market Capitalization [USD]||Dividend Yield Current Rank||Dividend Yield 3 Year Median Rank||Sustainability Factor Score||Yield Factor|
|Kkr & Co Lp||10.8||99%||100%||6%||100%|
|Blackstone Group Lp||27.3||99%||99%||34%||99%|
|Kinder Morgan Inc||28.0||100%||96%||3%||98%|
Source: Produced by the author
S&P 500 dividend structure at a glance
After calculating the dividend yield and sustainability factors for every company in the S&P 500 we plotted the data in a x-y-scatter diagram. The key insight from the scatter plot below is the strong negative correlation between the dividend yield and sustainability factors. It turns out that it is incredibly hard for a firm to be a high and sustainable dividend payer. Only a handful of companies are able to stay within the "Exceptional Dividend Payer" category where it has both a high yield and sustainability. Firms that offer low yields with low capital flexibly are rated as poor dividend payers.
Source: Prepared by the Author
In order to answer the question "Who is the best dividend payer of the S&P 500?" we use the graph below to visually identify the stock that best fits the "Exceptional Div. Payer" quadrant. As the title of the article suggest this company is Western Union. Quite uniquely Western Union is able to have a current dividend yield of 3.8% while maintaining a sustainability score higher than 82% of firms in the S&P 500. Other names that meet our dividend strategy criteria are Viacom (NASDAQ:VIAB), CA Inc (NASDAQ:CA) and Invesco (NYSE:IVZ).
Top 10 dividend names by yield and sustainability (Average score)
|Name||Market Capitalization [USD]||Sustainability Factor Score||Yield Factor||Total Score|
|Western Union Co||8.6||82%||81%||82%|
|National Oilwell Varco Inc||11.1||64%||77%||70%|
Investors looking for both yield and dividend growth going forward should definitely considered investing in some of the firms we have listed today. In our view Western Union is the best "exceptional div. payer" today as it possesses the highest combination of sustainability and yield. Going forward us from the NU Student Value Fund would like to continue to post our view of the dividend world. Please make sure to leave a comment in the comment sections if you have one!
Disclosure: I am/we are long GILD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.