Key Metrics for Determining Which Companies Are Likely to Increase Dividends

by: Efficient Alpha

Shareholders of J.M. Smucker Co. (NYSE:SJM) received a very early Christmas present last week as the company announced it was raising its dividend for the second time this year. The jelly and jam maker is joining a long list of other companies in an effort to disburse more cash to shareholders. By the time you are reading this, Smucker shares will already reflect the increased dividend, so the question is, “Who else will be increasing their dividend soon?”

The short answer is lots. Barclays Capital’s Jeffrey Meli told Bloomberg last week that corporations are facing ‘ripe’ conditions to increase dividends and buy back stock after hoarding cash over the last few years. Once macroeconomic stability returns, companies will need to invest or spend some of the historic $1.9 trillion in cash they have amassed since the market’s meltdown.

Meli figures this to happen in the third quarter, a view I share in an article explaining why the market will do well in August. While I do not believe that macroeconomic ‘stability’ will necessarily be overwhelmingly positive yet this year, I do believe some significant headwinds will diminish to make it easier for companies to do business.

Other than investing in the broad market indices, knowing that many companies will soon be using their cash stash does not particularly help an investor. A look at some key metrics may help determine those companies more likely to increase payouts to shareholders.

It would be folly to predict which companies not currently paying a dividend would soon initiate, so the first screen will be current dividend payers. Non-dividend paying companies are more likely to use their cash for investment and buyback rather than to initiate a dividend.

The next two screens are return on assets and debt to equity. The two metrics are related in that debt to equity, or leverage, is used with return on assets to find return on equity. ROE could be used as a screen but there would be some redundancy if used with leverage as well.

Return on assets is a good measure of operational profitability. If the company is not able to earn a return on operations high enough to justify additional investment, then excess cash should be paid out to shareholders. There is a caveat here that if the company’s ROA is too low, the investor should look for more profitable alternatives. The screen below used a current ROA of at least 5% and a five year average of less than 12%. Amount of leverage on the balance sheet is important as well.

The efficient use of debt is a deciding factor for highly profitable companies, but a highly leveraged company may be tempted to use excess cash to pay down debt rather than increase its dividend. The screen below will look for companies with debt to equity of less than 10 percent.

The last screen will look for companies with considerable cash on their balance sheet relative short-term liabilities. The cash ratio is current assets minus inventory and receivables divided by current liabilities, and it helps to ensure that the company has excess cash on hand. Increase in cash can also be used to find companies that have significantly increased their cash holdings. The screen below (click to enlarge image) looks for companies with at least three times the cash available relative to current liabilities.

Finish Line (NASDAQ:FINL), the retailer of performance and athletic shoes and apparel, announced a regular cash dividend of $.05 per share on July 21st payable on September 12th. MarketAxess (NASDAQ:MKTX) has a market cap of almost one billion and operates an electronic trading platform for corporate bonds and fixed income instruments. Cognex (NASDAQ:CGNX) provides machine vision products to manufacturers for process automation. MKS Instruments (NASDAQ:MKSI) has a market cap of $1.4 billion and provides instruments, subsystems, and process control solutions for the manufacturing industry.

This does not constitute a recommendation in the companies listed above. These stocks share characteristics that I believe will lead to increased dividends in the future. Investors should perform their own due diligence to ensure other characteristics align with their own investment goals. It should also be noted that dividend screens will often be skewed towards some sectors.

By explicitly screening for dividends, the investor will limit themselves to fewer technology companies. Looking for companies with average to below-average ROA will also limit the screen to more mature industries where competitive pressures have sliced margins thin, i.e. retail. It is important for the investor to understand how these screens will effect their investments and how they coincide with the investor’s goals and needs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.