Cash flow coverage of the dividend paid is more relevant than dividend payout
Traditional dividend analysis focuses on dividend payout from net income, but the focus really should be on the cash flow coverage of dividends in order to determine their quality and sustainability. The question should be – are dividends being paid from operating, investing and issuance cash flows?, or is the beginning cash balance needed to make this payment? Cash dividends are assumed to be paid only after net debt repayments. Cash outflow for share buybacks are considered discretionary and subordinate to the cash required to support dividend policy.
Dividends that are fully covered from operating and investing cash flow net of any cash outflow from debt repayments and net of a decrease in deposits (for banks) are considered to be “high quality”. Those that require an additional net cash inflow from issuance of debt or equity are categorized as “medium quality”. If operating, investing and issuance cash flows are not sufficient to fund the dividend and the beginning cash balance is used, the dividend is referred to as “low quality”.
This last category is most at risk of a dividend cut though we recognize that companies that have a large cash balance could continue to pay dividends even with a “low quality” dividend profile. For all these definitions, we assume the cash outlay for share buybacks is discretionary and can instead be used to support dividends.
Analyzing Dividend Quality
Users of the AnalytixInsight platform have full access to information on dividend quality of a stock. Lets look at Exxon (XOM-US) as an example. Not only do we analyze the dividend quality and coverage ratios for Exxon for the last 5 years, we also compare and contrast it with its selected peers. Here is a small excerpt from our report on Exxon:
XOM-US has a high quality dividend.
The source of the company's cash to support the dividend paid in 2010 is operating cash flow (coverage of 5.7x), investing cash flow (coverage of -2.8x), issuance cash flow (coverage of -2.2x) and beginning period cash (coverage of 1.3x), for a total dividend coverage of 2.0x. XOM-US's issuance cash flow includes outflows from net debt repayment (coverage of -0.7x) and net share buybacks (coverage of -1.4x). Thus, the total coverage including share buybacks is 3.4x, which reflects our assumption that the cash paid for share buybacks is discretionary and could instead be used to pay dividends.
These coverage ratio factors imply that the firm's dividends are wholly paid from operating and investing cash flows net of any debt repayments, which suggests a high dividend quality. XOM-US's dividend quality is in line with a majority of its peers, which comprise 5 high quality, 4 medium quality and 1 low quality.
Dividend quality varied between high and low over the last five years.
XOM-US has paid a dividend in each of its last five years. The distribution of dividend quality over this period consists of 4 high and 1 low. In particular, the dividend paid in 2010 was of high quality, compared to a low quality dividend in the prior year.
The complete analysis of dividends and more can be accessed from the Corporate Actions tab on Exxon.
Screening for stocks based on Dividend Quality
You might say – all the analysis is well and good, but how do I find stocks that have high quality dividends. Our stock screener is designed to address that very need. Here is a screencap of the stock screener – we have filtered it to look for companies that trade in the US, with market cap of over $2.5B, dividend yield of 5% or higher with a High Quality Dividend yield. The screen has 49 results that you can delve into, or add additional criteria to fine tune your search.
For those of you that missed part I – it is available here