If you're looking to buy a partial ownership stake in a publicly-traded company, then there are a number of things that you should consider before doing so. These things include the company's business model, historical earnings growth and corporate governance. Another thing that you may want to consider is the dividend.
Dividends are very important as they can provide some cushion for investors to the downside and can also signal confidence from management in the company's future. Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. Most of them prefer to diversify into many different sectors of the economy in order to spread out their risk.
Today, let's take a look at the dividends of IBM (IBM), a huge player in the technology sector of the economy. Let's see how the dividend of IBM stacks up in terms of strength and sustainability and what investors can expect going forward.
Before I go any further, I realize that as with many other technology stocks, the dividend is not the main reason why most people would buy IBM. However, given that its dividend yield was recently above 2% and that it has a strong dividend growth history, it has attracted the attention of numerous dividend growth investors. So, a look at the dividend can be an important component in the due diligence of many when it comes to IBM.
The first and most obvious consideration when evaluating a company's dividend is the dividend yield, which represents the percentage of your investment that you'll receive back over the next 12 months at current share prices and dividend payouts.
IBM currently yields 1.9%. This is the yield that is based on dividend payments that were made over the last 12 months. Over the last several years, the company has announced dividend increases at the end of April, so the yield should go up soon if the company continues this policy. While small, the company's dividend yield is near a 5-year high of 2.2% that was set back in February of this year. Over the last five years, the company's dividend yield has ranged between 1.4% and 2.2%.
When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation as well as to show confidence in management in the company's outlook.
Table 1: Dividend Growth Rates Of IBM
From Table 1, we can see that IBM has increased its dividend at a double-digit rate each year over the last five years. In fact, a closer look at the company's dividend history shows double-digit increases every year going back to 2004. Overall, the company has increased its dividend every year for the last 18 years. The company's dividends go all the way back to 1913.
Free cash flow payout ratio
While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better as they leave more room available for future dividend increases or other uses of the capital.
Free cash flow is the cash flow a company generates in its operations minus capital expenditures.
Table 2: Free Cash Flow Payout Ratios of IBM
Over the past year, IBM paid out just 27% of its free cash flow to shareholders in the form of dividends. This percentage is slightly higher than what was seen during the three years before that.
With dividends consuming just over a quarter of the company's free cash flow, it can be concluded that the dividend from IBM is in no danger at this point in time with plenty of room to spare for future dividend increases and other value-creating activities.
Interest Coverage Ratio
One of the ways in which we can determine whether or not a company will have trouble paying its dividend in the future is by looking at how much interest it has to pay every year. More money spent on interest means less money that is left for dividends. To determine the effect that debt has on a company's ability to pay its dividends and funds other activities, I calculate the interest coverage ratio. This ratio is calculated by dividing the company's earnings before interest and taxes by its interest payments over the year. You generally like to see this ratio at or above 2. If it's below this figure, then that may signal trouble ahead for the company in question.
Fortunately, this is not a problem at all for IBM. Its earnings before interest and taxes over 2013 of $19.9B covered its interest obligations almost 50 times. At this point, debt is not having any effect at all on the company's ability to pay its dividends.
Earnings per share growth forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth since earnings growth drives free cash flow growth, which ultimately drives dividend growth.
This year, analysts expect IBM to generate non-GAAP earnings per share of $17.83 versus the $16.99 per share that was produced in 2013. This would be a 4.9% increase. The company is then expected to generate 11% earnings per share growth in 2015.
At this level of earnings per share growth, IBM should have no problem at all in continuing its recent history of dividend increases.
The dividend of IBM is currently well-supported by its free cash flow. Management of IBM has shown a commitment toward dividend increases through its streak of annual double-digit dividend growth that goes back to 2004. Overall, the company has increased its dividend every year for the last 18 years. The company will more than likely announce another increase by the end of this month, or the beginning of next month.
With dividends currently occupying just over one-quarter of free cash flow, and mid to high single-digit earnings per share growth on the horizon, IBM should have no problem at all when it comes to continuing its streak of double-digit dividend increases in the near term, especially if the company is willing to expand its payout ratio. So, in terms of magnitude, I would be expecting more of the same increases that we have seen over the last couple of years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.