Seeking Alpha

One investing goal is finding undervalued companies where the dividend is not only safe but has the ability to grow going forward, providing a steady income stream. The idea for this article came after reading David Van Knapp's article titled, "Modern Dividend Theory Explained Part 2: Risk And Diversification." David stated:

I am not aware of an analogous mathematical measure of the risk that a dividend stream will be reduced. Clearly, it is a function of the stability and predictability of dividends themselves. For now, I do not have nor am I going to attempt to invent a mathematical function that describes the risk to dividends or to dividend growth. Common experience suggests that the risk to dividends is far lower than price risk, but I don't know how to quantify that.

The following is certainly not a complicated mathematical algorithm that would make a derivative expert blush but an overly simple visual to measure dividend safety. We will look at a few examples that illustrate the following:

• The dividend is safe with room for growth
• The dividend is safe but growth could be slowing
• The dividend is high risk.

The metric used is payout to FCF (free cash flow) per share. The premise is simple, the lower the ratio the safer the dividend and the ability to grow the dividend. A high ratio equates to higher dividend risk. We define FCF as cash from operations minus capital expenditures. It is important to use FCF per share to account for any acquisitions which may increase FCF but lower it on a per share basis.

Another important measure is consistency, i.e., are any trends clearly visible. Is the gap between the FCF and dividend line narrowing or expanding. Do the trends reflect, in David's words, "the stability and predictability of dividends themselves?"

Example 1: Microsoft (MSFT), a company whose dividend is not only safe but has room to grow. The visuals plot the following metrics:

• FCF per share (left axis)
• Dividend per share (left axis)
• Payout ratio (right axis)

MSFT paid out a special dividend which explains the spike in 2005. Notice how consistent FCF performance has been; a few ups and downs but overall an upward trend. The payout ratio is extremely low at 21%. Given MSFT's history of dividend increases combined with the low payout ratio leads to the belief this trend will continue well into the future.

Example 2: McDonald's (MCD) attributes are similar to MSFT's. The exception being MCD has a higher payout ratio of 60% through 2011. The current dividend is \$2.80 pushing the ratio above 60% based on trailing twelve month FCF.

I use 65% as a ceiling when looking at both safety and the ability to continue future dividend increases. There is nothing magical about this number. One might use a higher or lower ratio based on additional factors such as risk tolerance, debt schedules etc. The point here being the margin of safety is less than MSFT by equating lower FCF payout ratios with lower risk. As long as MCD continues to grow FCF the dividend will continue upward over the long term.

Example 3: AT&T (T). Here the question is can they continue to grow the dividend?

The payout ratio has exceeded 70% so one might question the ability to consistently increase the dividend longer term. In addition a FCF payout ratio over 70% would be cause for concern since there is very little room for error. T sports an attractive dividend exceeding 5% but any downtrend in FCF could trigger a cut down the road.

Example 4: Frontier Communications (FTR); the warning signs of high risk.

Frontier acquired approximately 4.8 million access lines from Verizon (VZ), tripling the size of the company and consummated in 2010. The dividend was cut from \$1.00 to \$0.75 upon closing. This is an example of why we use FCF per share and not overall FCF. FCF has increased but the FCF per share is trending down due to dilution generated from the acquisition.

There is consistency in the trends, just not the type we are looking for. FCF peaked in 2006 and the trend has been down ever since while the ratio approached 100%. The dividend was cut again in 2012 from \$0.75 to \$0.40 lowering the ratio to 66%.

The cut surprised many since management called the previous dividend safe and put out their own measure of FCF reinforcing their statements. The lesson here is to stick to the traditional FCF measure and ignore alternate methods. The signs were there but became clouded due to management comments and metrics. The attraction today is the very high yield but that comes with high risk as the FCF trend indicates.

Conclusion: There are always exceptions to the rule but this serves as a quick, conservative method to get a feel for the safety of the dividend. We all know trends can quickly reverse so once one decides on a few candidates some additional checks might be:

• Determine if there is any news specific to the company or industry that would negatively impact FCF over the longer term.
• Where is the cash generated, i.e., will cash need to be repatriated to support or grow the dividend or will tax consequences make this unlikely.

Finally the dividend is not going help if you buy into a company that is overvalued. Focus on companies with a solid dividend track record trading at a discount to fair value.

Disclosure: I am long MSFT, T, FTR.