With treasury yields at historic lows, many investors have resorted to buying dividend-paying stocks in search of higher yields. Investing in solid dividend-paying stocks over time has many advantages, including a tax rate of only 15% for qualified dividends, and numerous studies proving dividends have accounted for a large percentage of the S&P 500 return. While the S&P is still below where it was in 2000 many quality dividend stocks have provided solid returns for investors. This article will explain the proper way investors should analyze a dividend stock's future prospects and the dividend's security.
It's About The Business:
The most important part of analyzing a dividend stock is understanding the company's business and future prospects. While many investors simply look at the current yield, it is crucial that investors focus on investing in a strong, growing business before they analyze yield. The best dividend stocks give investors the opportunity for price appreciation and regular dividend increases.
Factors to Consider:
- Are the company's future growth prospects strong, or are they in a declining industry?
- Is the company's underline business volatile, or relatively stable?
- Is the company excessively leveraged?
- Does the company have a long history of dividends with regular increases?
- Can the company comfortably afford to pay the current dividend, or even raise it?
Taking a Long-Term Look:
Investors need to analyze a dividend's viability by looking at a full economic cycle, not just the current year. Many companies' dividends appear sustainable during boom periods, only to be cut when the economy enters a downturn, as was seen in the 2008 financial crisis.
The Importance of FCF as Opposed to NI:
Dividends are paid with cash, not NI. When analyzing a dividend, investors should examine operating cash flow less required capital expenditures to get a full understanding of a company's dividend sustainability.
A Few Examples:
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Intel has been able to grow NI, FCF and dividends at a high CAGR in what has been a tough environment since 2007. The only YOY decrease in FCF was in 2008, which dropped by 25%, but it more than adequately covered the dividend. Additionally, Debt to Total Capital is extremely conservative at 14%. It is clear Intel has a strong growing business that will allow them to not only maintain the current dividend, but regularly raise it.
Note: After writing this article Intel announced a 7.1% dividend increase, which is the third raise in 18 months.
Verizon has a declining NI, but has managed to grow FCF at an impressive CAGR of 13% since 2007. The company also increased the dividend, albeit at a much lower rate than Intel. Verizon's 2011 dividend was 42% of FCF, which is in-line with the 5-year average payout ratio of 44%. An additional cushion is its large cash position of $4.70 per share. Debt to Total Capital is relatively higher at 59%, however still manageable. When analyzing Verizon with traditional NI metrics the dividend looks risky with a dividend payout ratio of 215%, but a more thorough analysis of FCF confirms the company's dividend appears sustainable.
Johnson & Johnson
Johnson & Johnson's NI and FCF have been relatively flat since 2007, although they have been able to increase dividends at a 7% CAGR. The company has been paying dividends since 1944, and has raised the dividend every year for almost 50 years. 2011 Dividends to FCF was 55%, which is in-line with their five-year average of 49%. With Debt to Total Capital of 26%, a cash balance of $8.92 per share, and historically low volatility in NI and FCF (with the exception of 2011 due to large product recalls), it is clear Johnson & Johnson has a sustainable dividend that will be able to be raised as the company grows.
Windstream's primary business is providing basic telephone services, which is currently deteriorating rapidly due to the use of mobile phones, but they are in the process of shifting to a broadband and Internet telecom focus through several acquisitions and a merger with Paetec. A 34% annual decline in NI since 2007 is cause for concern, but most telecom companies have large non-cash depreciation expenses, although FCF also declined at a CAGR of 6%. The dividend payout ratio in 2011 was 303%, but investors should evaluate the dividend sustainability with FCF, not NI. 2011 Dividends to FCF was 111%, which would be unsustainable in the long term, but dividends to 5-year average FCF is 74% (high, however possibly sustainable). The steady increase in debt over the years has increased the Debt to Total Capital ratio to 86% in 2011, which is dangerously high. Cash of only $.42 per share doesn't leave investors with a margin of safety if the company hits a rough patch. There is a concern surrounding the sustainability of Windstream's dividend. Whether they will able to maintain the current annual dividend of $1 per share will depend on how quickly and smoothly they can transition into a more broadband and Internet telecom focus, and the type of boost the company will see from the merger with Paetec.
Frontier communications was chosen as a prime example of a company with an unsustainable dividend. Frontier had a 2011 dividend to FCF payout of 101%, and a dividend to five-year average FCF payout of 132%. Factoring in a Debt to Total Capital ratio of 65%, cash per share of only $.33, and nothing in the immediate pipeline to provide a sizable increase in FCF, it isn't surprising Frontier cut its annual dividend in 2012 from $.75 per share to $.40 per share.
Investors should analyze a dividend stock's business first. Companies with strong growth prospects and commitment to rewarding shareholders offer investors the greatest opportunity for future price appreciation and dividend growth. A thorough analysis of potential investments will help to avoid the dividend trap. A strong company with a bright future, but lower yield, typically has better long-term prospects than a high-yield stock in a bad business that is struggling to pay its shareholders. Use FCF in lieu of NI based metrics, and look to the past, as it provides a window to the future.