Dividend growth investing is lots of fun, especially when investors have a systematic dividend analysis process to separate dividends that are safe from those that are not. Unfortunately, most dividend analysis that we've seen is backward-looking, and as the recent financial crisis has taught us, forward-looking analysis is all that matters. To help the financial advisor and individual investor from falling into the traps of yesteryear, we've created a forward-looking assessment of dividend safety in 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 company's net cash (or debt) 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 investment merits of Medtronic (NYSE:MDT), as well as its dividend under this framework.
To view why in October of last year we thought Medtronic was worth $44 per share (about where it is trading today) when it was trading hands at just $33, please click here.
Return on Invested Capital
Medtronic's dividend yield is above average, offering a 2.5% annual payout at recent price levels. We prefer yields above 3%, and generally don't include firms with yields below 2% in our dividend growth portfolio.
We think the safety of Medtronic's dividend is good (please see our definitions at the bottom of this article). 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). 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 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 Medtronic, this score is 2.7, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies. For example, Wal-Mart (NYSE:WMT) scores a 1.4 on this measure. Also, for firms that have a score below 1 or that have a negative score, the risk of a dividend cut in the future is certainly elevated. In fact, the Valuentum Dividend Cushion caught all dividend cuts in our non-financial coverage universe, except for one, which subsequently raised its dividend above pre-cut levels (meaning it shouldn't have cut it in the first place). The Dividend Cushion also caught the recent cuts by JC Penney (NYSE:JCP)--its score was 0.9--and SuperValu (NYSE:SVU)--its score was -10. To view our call that SuperValu would cut its dividend before it did so, please click here. Pretty neat tool, don't you think? We use our dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter (please see our links on the left sidebar for more information).
Now on to the potential growth of Medtronic'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 growth rate, and a nice dividend cushion, its future potential dividend growth would be excellent, which is the case for Medtronic. The firm has tremendous excess capacity.
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 Medtronic's case, we think the shares are fairly valued, so the risk of capital loss medium. If we thought the shares were undervalued, the risk of capital loss would be low.
All things considered, the growth potential and safety of Medtronic's dividend are attractive, making the firm worth considering as a potential income idea.
Additional disclosure: MDT is included in our Dividend Growth portfolio.