Beyond The Payout Ratio

6/11/2012


The concept of the payout ratio is simple. The more of its profits a company pays out in dividends, the less is left to spend growing the business or dealing with the unexpected.

In general, we prefer stocks with payout ratios of 60% or lower. That keeps us out of many high-yielding stocks, but it also keeps us out of companies with little flexibility to adapt to a changing market. The tradeoff makes sense to us. But what if the traditional payout ratio doesn't tell the true story?

Earnings, also called profits, remain the most popular way to measure company performance. But they don't always reflect real purchasing power because they take into account noncash gains and expenses. For that reason, the Forecasts also likes to look at a company's cash flow.

Operating cash flow adds such costs as depreciation and amortization back to net earnings and also adjusts for other noncash items, such as the change in working capital. Eliminating noncash items provides a clearer picture of how much cash a company generates. Since dividends are paid in cash, that picture is important.

Free cash flow takes the process a step further, considering other cash outlays not deducted from profits. We start with operating cash flow, then subtract spending on dividends and capital projects. Free cash flow measures how much cash a company has left after all of its outlays.

Free cash flow tends to be volatile. For example, the S&P 1500 Index's 2005 dividend represented 63% of free cash flow. In 2006, the per-share dividend rose 14%, yet was nearly six times larger than free cash flow, which plummeted. While those extremes make for messy trends, there is value in analyzing how a company's dividend compares to free cash flow.

As the table below illustrates, the median dividend-paying stock in the S&P 1500 Index has a payout ratio (indicated dividend divided by trailing 12-month earnings or cash flow) of 34% of earnings, 21% of operating cash flow, and 41% of free cash flow. While many financial and utility stocks don't provide traditional cash-flow numbers, and the volatility of free cash flow can distort the picture, payout ratios based on cash flows provide a useful check against the traditional payout ratio in most sectors.

SECTOR PAYOUT RATIOS
All of the data below except the number of stocks reflect medians for stocks in a given sector or index. Median payout ratios differ greatly from sector to sector, and investors should take sector-specific trends into account when analyzing individual stocks. Companies that don't pay dividends tend to generate more profit and cash-flow growth than dividend-payers. Yet dividend-payers have outperformed over the last one and three years.
Dividend Payout Ratio
Profit Growth
Operating-Cash-
Flow Growth
Free-Cash-
Flow Growth
Total Return
Sector
(No. Of Div.-Paying Cos.)
Yield
(%)

Vs.
Earnings
(%)

Vs.
Oper.
Cash
Flow
(%)
Vs.
Free
Cash
Flow
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
Consumer
Discretionary (137)
3.7
58
42
109
8
7
10
6
11
6
7
18
Consumer
Staples (59)
3.2
48
33
77
8
8
12
1
17
(4)
3
16
Energy (47)
3.2
50
41
98
8
9
6
7
7
13
5
21
Financials (230)
2.7
36
NM
NM
10
9
NM
NM
NM
NM
(1)
15
Health Care (53)
2.2
34
23
49
9
7
14
3
(4)
(3)
(2)
13
Industrials (165)
1.9
26
17
31
14
12
9
4
1
(2)
(2)
16
Materials (81)
1.6
21
11
23
14
7
5
1
(10)
1
(10)
8
Technology (83)
1.8
23
14
23
16
11
7
3
2
8
0
14
Telecom Services (10)
1.4
18
9
11
7
2
29
5
22
4
0
11
Utilities (63)
0.6
10
NM
NM
19
7
NM
NM
NM
NM
(2)
8
S&P 1500 Index Div.
Payers (928)
2.4
35
22
42
11
8
10
4
5
4
0
15
S&P 1500 Index
Nonpayers (572)
0.0
0
0
0
13
15
13
10
7
10
(10)
12
NM Not meaningful because too few companies in the sector report cash-flow data.

In the table below, we list 13 A-rated stocks with payout ratios below the median for their sector. By definition, half of the values in a data set are higher than the median, and half are lower. All also seem capable of generating the profit and cash-flow growth needed to support future dividend hikes. Three of our favorites are reviewed below.

Agilent Technologies ($38; A) paid its first quarterly dividend in April. The indicated payout of $0.40 ($0.10 per quarter) equates to a yield of 1.0% and just 12% of the company's trailing 12-month earnings. Such a payout ratio leaves the maker of electronic instruments plenty of flexibility for future dividend growth.

Agilent's end-market diversification provides the wherewithal to ride out downturns without sacrificing the ability to tap high-growth niches. The cyclical electronic-measurement business generates about half of Agilent's revenue, with the rest coming from the more stable chemical-analysis and life-sciences markets. The company is best known for selling to technology and health-care customers. But in the April quarter, Agilent generated substantial revenue from chemical/energy (13% of sales), aerospace/defense (10%), forensics/environmental (10%), and food (6%) businesses.

The consensus projects per-share-profit growth of 9% in the fiscal year ending in October and 11% in fiscal 2013. Those profit targets are on the rise, and we see them as overly conservative. Agilent is a Focus List Buy and a Long-Term Buy.


Cisco Systems ($16; CSCO) is another relative newcomer to dividends, paying its first in April 2011, then raising the payout 33% a year later. The networking-equipment giant yields 2.0%, paying out just 21% of earnings and 20% of free cash flow.

Since posting a solid April quarter but offering disappointing revenue guidance, Cisco shares have fallen 14%. Weakness in Europe and tighter corporate budgets are legitimate concerns. But Cisco's punishment seems overly severe, given the company's competitive advantages. Cisco regained market share from weaker rivals in the April quarter, and a huge installed customer base and broad geographic reach leave the company positioned to outperform during periods of tight technology spending.

In the wake of Cisco's guidance, the consensus projects per-share-profit growth of 14% in the July quarter and 5% in the fiscal year ending July 2013. Cisco's aggressive cost cuts (operating profit margins reached 27.8% over the last four quarters, up from 26.0% a year earlier) and buybacks (share count fell 1.5% over the last year and 7% over the last two) offer reasons for optimism about its ability to top the modest 2013 profit target. At nine times trailing earnings, Cisco trades at a 43% discount to its peer group and 45% below its own three-year average P/E ratio. Cisco is a Buy and a Long-Term Buy.


In contrast to the two dividend newbies covered above, Wal-Mart Stores ($66; WMT) has boosted its payout in each of the last 38 years. The retail titan raised its dividend 9% in April and has delivered annualized dividend growth of more than 20% over the last five years.

Allegations of bribery in Mexico cast a shadow on the shares. And with at least two federal probes into Wal-Mart's practices under way, don't expect the issue to disappear any time soon. Worst-case scenarios put fines in the hundreds of millions of dollars. But such headlines generally produce more smoke than fire, as evidenced by the stock's recent strength. Wal-Mart has risen 11% since releasing unexpectedly strong April-quarter results.

Same-store-sales growth of 2.6% in the April quarter marked the third consecutive quarterly gain and the best in three years. Both store traffic and average ticket prices are on the rise, helped by Wal-Mart's addition of new inventory. Consensus per-share-profit estimates call for 9% growth in the fiscal years ending January 2013 and January 2014; estimates for both years have risen over the last 30 days. Wal-Mart is a Long-Term Buy.

STOCKS WITH ATTRACTIVE PAYOUT RATIOS
All 13 of the A-rated stocks below yield at least 1% but pay out less of their profits and cash flows in dividends than the median stock in their sector. Stocks recommended for purchase are presented in bold.
Div. Payout Ratios
Profit Growth
Operating-Cash-
Flow Growth
Free-Cash-
Flow Growth
Company (Price; Ticker)
Div.
($)
Yield
(%)
Vs.
Earnings
(%)
Vs.
Oper.
Cash
Flow
(%)
Vs.
Free
Cash
Flow
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
12
Mos.
(%)
3 Yrs.
(Annual.)
(%)
Sector
Aetna ($42; AET)
0.70
1.7
13
8
11
23
20
158
11
175
12
Health Care
Aflac ($39; AFL)
1.32
3.4
26
5
5
14
21
55
31
59
33
Financials
Agilent Tech.
($38; A)
0.40
1.0
12
11
14
30
40
32
30
30
35
Health Care
American Express
($54; AXP)
0.80
1.5
20
7
8
26
35
47
36
56
46
Financials
CF Industries
($167; CF)
1.60
1.0
7
5
6
136
27
11
47
12
57
Materials
Cisco Systems
($16; CSCO)
0.32
2.0
21
16
20
16
8
7
(1)
(2)
(5)
Technology
CVS Caremark
($44; CVS)
0.65
1.5
24
13
21
9
5
21
19
31
46
Consumer
Staples
Macy's ($37; M)
0.80
2.2
27
15
24
29
50
33
8
11
16
Consumer
Discretion.
MetLife ($28; MET)
0.74
2.6
13
6
7
80
21
45
27
51
29
Financials
TJX Companies
($41; TJX)
0.46
1.1
21
14
26
37
27
56
26
139
37
Consumer
Discretion.
UnitedHealth
($56; UNH)
0.85
1.5
18
10
12
9
17
48
23
58
21
Health Care
Wal-Mart Stores
($66; WMT)
1.59
2.4
34
20
60
11
11
12
6
21
7
Consumer
Staples
WellPoint ($66; WLP)
1.15
1.7
16
11
15
(2)
21
22
9
11
3
Health Care

 


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