In this article, let's evaluate the investment merits of Broadcom (BRCM), as well as its dividend under the framework that we use to select dividend-growth stocks. For an in-depth analysis of why we think Broadcom is a ridiculous bargain at current levels, please click here. And to find out why we like its dividend, read on.
Return on Invested Capital
Dividend growth investing is lots of fun, especially if you have a systematic, forward-looking process to assess the safety and potential growth of a company's dividend. That is why we created a forward-looking assessment of dividend safety through our predictive dividend-cut indicator, the Valuentum Dividend Cushion. Though Broadcom's dividend yield is below average (right now), we think the safety of Broadcom's dividend is excellent (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.
Our framework in assessing dividend-growth stocks culminates in 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 Broadcom, this score is a whopping 9, 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 Valuentum 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. 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 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 (JCP)--it scored a 0.9--and SuperValu (SVU) - it scored a -10 (negative 10). To see how we used our Dividend Cushion to predict SuperValu's dividend cut in advance, please click here. 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 Broadcom'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 Broadcom. The firm has substantial excess cash-flow capacity to raise its dividend for many years to come.
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 Broadcom's case, we think the shares are fairly valued, so the risk of capital loss is low. In other words, Broadcom has qualities of the best of both worlds -- an undervalued stock with substantial dividend growth prospects. Still, we are waiting for the yield to move just a bit higher before considering it in our dividend-growth portfolio.