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. 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. That is why we created a forward-looking assessment of dividend safety through our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion. We use our future forecasts for free cash flow and expected dividends and consider the firm's net cash position to make sure that each company is able to pay out such dividend obligations to you -- long into the future. In this article, let's evaluate the dividend of Dr Pepper Snapple (DPS). (Our full report on Dr Pepper Snapple and hundreds of other companies can be found here.)
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We think the safety of its dividend is poor (please view the definitions of our scale below). 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.
That has led us to develop 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 of 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 Dr Pepper Snapple, this score is 1.2, offering some cushion and revealing some excess capacity for future dividend growth, but not much. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies. For example, Wal-Mart (WMT) scores a 1.4 on this measure. Our Dividend Cushion caught every dividend cut in our non-financial coverage universe, except for one, which subseqently raised its dividend to pre-cut levels in future years.
Now on to the potential growth of Dr Pepper's dividend. 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, the company has a nice dividend growth rate, and excellent cushion, its future potential dividend growth is excellent, which is not the case for Dr Pepper Snapple. We view the future potential dividend growth for the firm to be very poor, largely based on its poor Dividend Cushion score.
However, we don't stop there. By employing a matrix, one can see above that Dr Pepper Snapple has a controversial dividend--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 Dr Pepper Snapple's case, we think the shares are fairly valued, so the risk of capital loss is medium. If we thought Dr Pepper Snapple was undervalued, we'd consider the risk to be low.
All things considered, we're not tempted by Dr Pepper Snapple's dividend at all. We think there are much better dividend risk/reward profiles out there, and we are not considering the firm for inclusion to the portfolio in our Dividend Growth Newsletter at this time.
The chart below shows how we rate the company's dividend in each area: