Analyzing Dividend Safety Ratings Using The Super Secret Master Plan

|
Includes: CAT, EMR, JNJ, KO, XOM
by: DGI Guy

Summary

I propose a methodology for calculating a dividend safety rating.

The goal is to take feedback from the community and refine the methodology into a tool we can all use.

At first pass, it seems to be placing companies in order of dividend safety empirically.

Introduction

One of the things that I like about Tesla (NASDAQ:TSLA) is the Secret Tesla Motors Master Plan. For those of you who are unfamiliar, back in 2006, Elon Musk posted the company's business plan online. They have stuck to it (although they might have missed a deadline or two!) and delivered on it. The full disclosure is amazing in this day and age of companies who like to hide all details of what they are doing. I think of my investing style the same as the Tesla Master Plan.

DGI Guy Dividend Safety Master Plan

I am fine exposing 100% of my investing style and thoughts in hopes of two things:

  • It makes people new to investing better at investing.
  • Using the wealth of knowledge in the SA community to improve on my ability to invest.

I have been true to this master plan for some time. If you look through the history of my articles, you can see that I have made my actual portfolios relatively public. I have shared my goals. I have shared my failures (I am talking to you, Seadrill) and I have shared my successes.

I would like to continue today with the full disclosure by introducing a concept within my Master Plan around objectively measuring dividend safety with the development of the DGI Guy Secret Proprietary Safety Rating.

Taking a Step Back

As I have outlined before, I am a dividend growth investor. I look for companies who have made their payments consistently over long periods of time. I look for those companies to meet or beat inflation over the long term. To me, the safety of the dividend payment is my top concern.

I have a professional background in predictive analytics. One of the things that I have learned, and that is taught, is the simple model is the preferred model. It has a really cool term for nerds: parsimonious. The idea of this model is to find the fewest number of predictor variables that meet the goal of a desired level of explanation from the model. That is what we will do here.

For those of you who have been following the podcast that I do with Dr. Dividend, many of the contributors to the show have discussed looking at statement of cash flows. In addition there is focus on the credit ratings and overall level of debt. These three characteristics will be the primary inputs for judging dividend safety. By using only three variables out of the hundreds of things tracked by each company, it meets the goal of the parsimonious model. The outstanding question is does it meet the goal of explaining which dividends are safe and which are not?

Goal and Scale

I am going to put this out here as a starting point. I am looking to the community to help me refine the model. It will then be something we all can use to help become better investors.

When reviewing the information below, it will be important to note the scale on which things happen. For the majority of stocks covered, where Cash Flow from Operations is positive, the scale is bound by the traditional 0 to 100 scale (115 is the top number due to a multiplier used for credit rating as detailed below). If the company has negative cash flow then it can, in theory, scale down to negative infinity with negative 1000 being the realistic bottom. For simplicity, anything under 0 gets represented as 0. This means stay away!

The marginal impact of an additional ratings unit is relatively irrelevant. In comparing a company with a rating of 45 versus a company with a rating of 50, you should consider both safe. The scale is designed to tell you that 45 and 50 are safe, but 15 is something you should stay away from. For keeping things simple, you can think of the rating like the groups below.

  • Less Than 20: Stay Away
  • 21 to 40: Watch
  • Greater Than 40: Safe

Methodology

Below is an outline of suggestions that will go into the DGI Guy Secret Proprietary Safety Rating.

The first question is how long is the information relevant? For me, I first want to take a look at how long the company has been paying the dividend. Once it passes the test of something that I am comfortable with, then I look at the performance over the last 5 years. That will flow through the sections that we look at below. All will be analyzed over the past 5 years.

Everyone will have a different threshold as to how long they want the company to pay a dividend. For sake of ease, lets go with 25 years/Dividend Champions list for this report. It is not material to the methodology.

To create the DGI Guy Super Secret Proprietary Safety Rating, I am going to look at 4 things:

  • Interest Payments relative to Cash Flow Generated
  • Dividend Payments relative to Cash Flow Generated
  • Consistent Revenue Generation
  • Credit Rating from S&P

Remember, our goal is a parsimonious (simple) model. You don't want to get into a situation where you get an output from a model and do not understand how that output was generated.

Category 1 - Interest Payments

One of the things to keep in mind when reviewing a stock is to determine if the company can afford its current level of debt. To find out this information, look at the Income Statement in the Interest Expense line item. This is how much money the company is spending on interest payments. If they have no debt, it is 0. Obviously this costs cash as well as dividends. If the company has to pick between paying shareholders and paying debt, they will pick debt every time. If they do not, then it is time to jump ship as a conservative investor.

Category 2 - Dividend Payments

This is the fun stuff. This is the payment to you the shareholder. What we want to watch out for is any change in this payment that makes it look unreasonable relative to the value of cash coming in each quarter. We also want to make sure it is not taking up 100% of cash coming in each quarter!

Category 3 - Consistent Revenue Generation

I did not know what to title this section. What I want to know is if the company is getting better or worse at covering its dividend payments. For example, if the company has paid out 20% of cash each year for the past 4 years in dividends and this year it is paying out 90%, then there might be a problem.

Category 4 - Credit Ratings

For ease of access, I use S&P Credit Ratings. It is on Fast Graphs. You can use whatever is easiest for you. If you want to read about the various levels of credit rating, you can do so here. The way that I see this coming into play is a third party verification that the company can pay its debt. Thus, for applicability to the model, it should be used as a multiplier for the Interest Payment Section. I propose the following:

Rating

Multiplier

AAA or Greater

15%

AA- to AA+

10%

A- to A+

5%

BBB+

Flat

BBB and Under

-10%

There is no magic to this suggestion. It is simply a way to incorporate third party reviews of the company's ability to pay its bills. Keeping with my example, Coca-Cola (NYSE:KO) is currently rated AA-. This gives it a 10% bump in the interest payment section.

Calculation

This is a pretty simple process and I have a spreadsheet to help!

1. Get all the historic information for FCF, Dividends and Interest

2. Calculate a Dividend / FCF metric by year.

3. Calculate a Div / (FCF + Interest) metric by year.

  • Note: FCF includes payments for interest. This backs out those payments and looks at total cash generation to get a picture of what the dividend looks like relative to total cash generation

4. Calculated a weighted version of numbers 2 and 3

  • I am using 25% on the FCF + interest and 75% on FCF alone

5. Calculate a moving average of the weighted figure

6. Take a ratio of the moving average relative to the weighted average.

7. Covert this to the 1 to 100 scale.

That is it. It is probably easier to see what is being done by looking at the spreadsheet.

Results

So where does that leave us? Well, let's look at a few stocks and you tell me if you think the scale is putting them in the correct order! As a reminder, the scale to use to review safety would be:

  • Less Than 20: Stay Away
  • 21 to 40: Watch
  • Greater Than 40: Safe

So here are the results of 5 stocks in the dividend investing space.

Stock

Rating

XOM

0

KO

29

CAT

31

JNJ

46

EMR

56

I want to provide one comment on XOM. I included it because it was 0. 0 is anything that falls under the scale. I think it was actually a -400. Take a look at its cash flow history. Take a look objectively at its dividend / FCF. It is negative. You might have the sentiment that the company will be able to turn things around. That is great. I hold XOM. I think they will be able to do that as well. This formula is not an anecdotal tool. It is an empirical tool. Keep that in mind when you are thinking about the results.

So, what do you think? How can we make this better together?

Disclosure: I am/we are long EMR, KO, JNJ, XOM.

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.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here