Dividend growth investing is lots of fun, especially if you have a systematic methodology to determining which companies' dividends are safe and which ones' aren't. That is why we created a forward-looking assessment of dividend safety in our innovative, predictive dividend-cut indicator, the Valuentum Dividend Cushion™. In this article, let's evaluate the investment merits of KLA-Tencor (KLAC), as well as its dividend under this unique but yet very straightforward framework.
Return on Invested Capital
KLA Tencor's dividend yield is above average, offering just below a 3.5% annual payout at recent price levels. We prefer yields above 3% and don't include firms with yields below 2% in our dividend growth portfolio.
We think the safety of KLA Tencor'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.
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. For KLA-Tencor, this score is 3.5, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. 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 (JCP) and SuperValu (SVU). Please click here to learn how the Valuentum Dividend Cushion predicted SuperValu's dividend cut.
Now on to the potential growth of KLA-Tencor'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 KLA-Tencor. The firm's excess cash-flow capacity is simply great.
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 KLA-Tencor'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, KLA-Tencor stands out to us as one of the better dividends. We are considering adding it to our dividend growth portfolio (please see links on our left sidebar for more information).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.