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Finding dividend stars

How to pick companies that will keep paying out
January 19, 2023

Investing for income is a divisive topic. Our 'Kick the dividend habit' cover feature (IC, 5 November 2020) argued it was time to stop obsessing over payouts. Other commentators are more forgiving: our Secret Buy-side columnist, writing for Investors’ Chronicle Alpha, points out that a dividend can be a useful incentive for an investor: after all, like New Year's resolutions, investing strategies are only worthwhile if you can stick to them.

Undeniably, macroeconomic conditions are fraught and regular income can act as a comfort blanket to help investors stay the course. And at times when capital growth is harder to come by, the income component takes on an added importance for total returns. Many retirees, meanwhile, have long relied on regular income streams from their investments.

In this context, resilient companies that have shown historical commitment to paying dividends are to be welcomed, especially if the country does face a period of stagflation (recession at the same time as high inflation, which is possible if new energy or food price shocks cause headline figures to spike again this year). As a broad collective, long-cherished income stocks like these are arguably a 'hold' at current valuations, even if it is more questionable whether now is a good time to buy.

When searching for good income payers, some basic sense checks can be made for starters. Dividend cover (the amount of times earnings per share covers dividend per share), came in at 2.04 times in 2022 for FTSE 100 companies, and research by broker AJ Bell suggests this ratio will stay above two times for the remainder of the year.  Scratching beneath the surface, however, investors should still ask themselves whether that picture of health is belied by – to take just one example, some end-of-cycle anomalies that provide a temporary boost to earnings forecast calculations.

But picking shares for income isn’t just about dividend cover, let alone dividend yield. Other sense checks involve the track record of the company: is a progressive dividend payout sustained not just by earnings growth but cash generation, too? On a related note, what are the competing thirsts within the business that cash liquidity must quench? Companies have interest payments and short-term financing costs that are getting more expensive as interest rates rise; suppliers may be offering less generous credit and customers may not be paying up as fast; input costs are rising; revenues may be falling soon if not already. To this list we can add the importance of monitoring tax expense and capital expenditure.

In the case of traditional dividend stalwarts like energy and utility companies, each of these issues is a source of government and regulatory risk. In short: amid rising economic uncertainty, the litany of potential calls on cash flow means picking a steady dividend growth company isn’t straightforward.

Identifying issues is one thing: factoring these in to valuation calculations raises a new set of questions. Understanding the premium offered by a dividend stock is relatively straightforward: high yields themselves are indicators of value and tools like the famous Gordon model ('The price of time', IC, 22 July 2022) use discounting of dividends to settle on the fair price of a share. Of course, while the dividend investor should seek sustainable payments rather than a high headline yield, some of the less spectacular percentage yields now on offer can underwhelm in the context of improved risk-free rates of return from government bonds. What follows is a run-through of many of the issues we have just outlined.

 

UK dividend compounders
NameMarket Cap (£mn)Fwd 12-mth PETrailing 12-mth DYTrailing EPS div coverTrailing interest coverMedian NTM Fwd DYFwd EPS growth current FYFwd EPS growth next FY3-month share price changeTest failed 
3i Group (III)13,7335.93.6%7.364.03.9%-31.1%-20.7%33%Forecast EPS growth
GSK (GSK)58,5889.95.3%4.59.04.0%18.2%6.8%5%Past EPS and DPS growth, forecast DPS growth
British American Tobacco (BATS)70,9337.96.9%7.28.0%11.3%8.7%-4%Past EPS and DS growth, div cover
Shell (SHEL)169,9986.03.3%5.614.03.9%136.6%-6.4%7%DPS has been cut past in the past five years,past EPS and DPS growth, forecast DPS growth
Rio Tinto (RIO)78,57810.88.4%1.643.86.0%-25.5%-19.8%27%Past EPS and DPS growth,forecast EPS and DPS growth
Imperial Brands (IMB)19,2256.96.9%1.28.77.2%11.3%8.6%2%DP been cut past in past five years,div cover, DPS growth, forecast DPS growth
National Grid (NG.)38,08714.25.0%1.72.95.6%-2.4%7.3%21%Forecast EPS and DPS growth,past DPS growth, earnings cover
Source: FactSet and Investors' Chronicle. Based on the IC Alpha dividend compounders screen

 

Dividend payers' pandemic reset

Two of the most important indicators for an income stock – and compulsory tests for many dividend screens – are the rate of past dividend growth, and a company that demonstrates commitment by not having cut its payout. The unique set of circumstances posed by the coronavirus pandemic toppled many so-called dividend aristocrats, however.

Some companies became less steadfast with distributions in this exceptional time. So, although history is important, these events remind us that there must be at least as great an emphasis placed on future dividend growth prospects. Analysing these requires nuance, and any assertion that dividends ought to rise with earnings must be tempered: free cash flow is what really matters for most businesses (with the exception of banks and other financial companies, for whom the metric is less appropriate).

Therefore, even simple sense checks such as dividend cover need reconfiguration. Investors should ask whether the picture is still so rosy if the metric cited by AJ Bell swaps out earnings for free cash flow. Is this more robust measure likely to hold up as well as 2023 earnings and dividend per share forecasts? We need to think what assumptions go into forecasting earnings, and about risks to the downside.

 

What proportion of profits will be turned into cash?

One quick litmus test is to ask whether a company has positive free cash flow and whether the trends in free cash flow (FCF) over time have been positive. FCF is the excess of a company’s operating cash flows over capital expenditure undertaken, More precisely, free cash flow to equity (FCFE) is cash flow from operations minus net capital expenditure and net borrowing, which gives the amount available to ordinary shareholders.

One thing to be wary of on this front is share-based payments, which is when a company decides to exchange some of its equity for goods and services received from suppliers. Strictly speaking this isn’t a cash payment, but it does obfuscate the amount of cash a company needs to cover all its business costs and expenses – and therefore what the ‘true’ free cash yield looks like.

Over the long run, dividends should be covered by FCFE, but there may be years when there are good reasons why this isn’t the case. It might raise eyebrows if trends and timings of replacement capex send FCFE negative, but dips shouldn’t overly be cause for alarm. When it comes to bigger one-off investments denting cash flow, investors shouldn’t be overly perturbed, on the proviso that the strategy is sound, and the company’s liquidity and solvency isn’t compromised.

Companies finding good projects to invest in (that will make more money for the business in future) is always a positive sign, and it would be wrong to assume this runs counter to the interests of income investors. And those investors can help the business, too: in his recent analysis, The Secret Buy-sider also advanced the argument that shareholders demanding at least some jam today is good for project decision making: having to sate the appetite of these investors keeps capital just scarce enough to force management to focus on only the best opportunities, and lessens the resources available for vanity projects. In other words, divis are all part of the efficient capital cycle eco-system.

Taking a step back from free cash flow, we should also remember that the relationship between cash flows from operations and the profits that companies are recognising is crucial. The cash conversion ratio – the percentage of earnings before interest and taxation that gets converted into cash from operations – should consistently be close to or above 100 per cent. (It can exceed 100 per cent because depreciation and amortisation, which are non-cash expenses, are added back.) This shows the firm is reliably paid for the sales it states as revenue.

 

Sustainable dividend growth depends on earnings quality

Earnings quality, ie earnings that are sustainable and can be grown, is paramount for income investors. This is pertinent when looking at aggregate FTSE 100 dividend cover. The UK blue chip index is highly concentrated and some of its biggest companies have just had, or are still in the middle of, bumper fiscal years. Oil majors Shell (SHEL) and BP (BP.) enjoyed a bonanza from the energy price spike and banks such as HSBC (HSBA), NatWest (NWG) and Standard Chartered (STAN) are expected to achieve big year-on-year earnings growth thanks in no small part to net interest income rising as base rates increase.

But profits can be lumpy, especially when they are a function of volatile factors such as energy prices. Generally, when profits are cyclical in nature (even if somewhat predictably so) dividend growth may be, too.

Furthermore, there is the question of exceptional items. How many companies are banking one off gains from disposals of a division, subsidiary business or large asset? Individual financial reports will flag these, and they need to be taken out of the reckoning when modelling earnings growth trends. It’s another reason not to lose sight of how cash flows from operations have changed from period to period – even prior to assessing free cash flow which includes irregular flows from investing/disposal and financing decisions.

 

Firms need to hang onto their cash

Rising interest costs is a theme we will see reverberate in the real economy in the months ahead. When interest rates shot up in 2022 the immediate issue was one of valuation for expensive shares; this year, effects on the costs companies themselves face to borrow will feed through. Floating rate, shorter term debt is now dearer and new longer-term finance (ie, corporate bonds) must now offer a higher yield. Where debt is part of the capital structure, lenders have a prior claim to cash over shareholders, so interest cover (the ease with which a company’s profits cover its obligations and how its cash generation meets them) is an essential test for the sustainability of dividends.

The secondary impacts tightening credit conditions may become evident in the behaviour of customers, too. That means company receivables are especially worth keeping an eye on in recessionary periods; not only is there a heightened risk of bad debts, but reliable customers could also take longer to pay. For customers, as for companies, delaying payables for as long as possible before incurring penalties is a form of cheap credit.

When widespread, these practices affect the operating cash flows of companies throughout the economy. Revenues are recognised when the contract obligations of sales are met, and associated costs and expenses are matched in the same period. Often, receipt of cash is not concurrent, so when payments are being delayed the discrepancies between accounting profit and cash flow statements widen.  

Monitoring activity ratios helps ascertain whether companies are on the receiving end of such changes in behaviour, with the net operating cycle a key indicator. This adds the number of days on average that a company has inventory on hand to the average days on which receivables are outstanding, then subtracts the number of days for payables. The result shows the gap between a company investing in working capital and it collecting cash proceeds from sales. Also known as the cash conversion cycle, shorter time periods here demonstrate a business has good liquidity.

Inventory turnover, which is the cost of goods sold divided by average inventory, can also point to trouble ahead. If the ratio is low (and therefore days of inventory on hand is high), then companies aren’t selling what they make fast enough. The chance of this problem occurring might be remote for high-margin companies that have strong demand for their products, but situations can decline rapidly in a period of high inflation.

 

Accounting choices and reported profit nuances

If UK companies, which operate under IFRS rules, account for inventory in cost of goods sold on a first in, first out (FIFO) basis, then those costs will be more expensive next year on account of rising prices. Therefore, even if sales are the same, inventory turnover would worsen, and that effect will be amplified if demand for products falls in 2023 as the economy weakens.

The cost of goods sold won’t see such a pronounced rise if companies use the weighted average cost (AVCO) method for inventory. That is also permitted under IFRS, but either way that recession risk remains. Should inventory become difficult to shift, it may need to be discounted before the end of the next fiscal year – as has been the case for several retailers of late – resulting in a writedown that would be recorded as a loss on the income statement. 

Writedowns in general are a potential cloud on the horizon when the productive value of assets face reassessment in recession. Most at risk are sectors with a high proportion of fixed assets like housebuilders and real estate investment trusts (Reits). Then there are the private equity investment companies which have whole portfolios that are notoriously slow to reflect new economic realities in their valuation.

Private equity may not be alone in taking a beating for the largesse of previous deals, however. Mergers and acquisitions, funded by cheap capital and conducted before the interest rate hiking cycle began, may prove costly in time. Where goodwill has been recorded on balance sheets because prices exceeded the value of tangible assets (as well as some intangible assets with finite lives that can be amortised: patents, for example), this must be reassessed. In a recession, some goodwill could be chalked off and the losses will hit companies’ net income.

Yet another accounting habit investors must consider is tax treatment. Companies are permitted flexibility in how they recognise expenses like depreciation and amortisation and hence how they make the most of their tax returns. For instance they may adopt a policy to spread the tax base of depreciable assets and hence the cash outflow of taxes payable over an acceptable timeframe.

On the income statement, however, companies mostly wish to maximise profit before tax, which can be aided by depreciating assets at a different rate. This may result in a higher tax expense but will also produce a higher net income. Over the life of an asset, tax expense and taxes payable will match, but there will be years when the cash outflow is greater.

All these issues are just part and parcel of understanding the relationships between the earnings and cash flow of any company. They provide important challenges to assumptions about earnings and dividend growth.

 

What should you pay for income shares?

Popular valuation methods are based on the logic that the price of a share today represents the sum of discounted presumed future cash flows from owning it, ie, for income investors, the dividends.  For mature companies with a history of paying and growing dividends, it is reasonable to value their shares using the Gordon growth model, a model for discounting dividends in perpetuity.

 

Gordon model – National Grid 
Risk free rate 3.5%
FTSE 100 long run TR8.7%
Beta 0.4
Required rate of return5.6%
  
Payout ratio 0.78
Earnings retention 0.22
ROE9.9%
constant divi growth rate2.2%
  
Latest year DPS0.51
  
Intrinsic value£15.32
Current share price £10.33
Source: FactSet and Investors' Chronicle

 

The first step is to estimate a reasonable required rate of return using the capital asset pricing model (CAPM). This introduces some important context: risky assets like shares should be valued in the context of the premium they offer over the risk-free return of a safe government bond yield.

The beta of a share (the measure of its price sensitivity to the change in market values) is multiplied by the difference between the market’s excess return compared with the risk-free rate. The resultant single stock equity premium is added to the risk-free rate to give a target that is theoretically commensurate with the shares' additional risk.

Step two is to factor in a constant growth rate that can be applied to the future stream of dividends. One way to do this is by multiplying the company’s return on equity (RoE) by its earnings retention rate (one minus the ratio of earnings paid out as dividends). Another, much cruder measure is to simply use historic dividend growth rates.

Step three involves multiplying the recent dividend per share (DPS) by one, plus the constant growth rate calculated in step two. This is divided by the required rate of return minus the constant growth rate to give the intrinsic value of the shares.

Our example suggests National Grid (NG.) is drastically undervalued but that is unlikely in an informationally efficient market. The 10-year gilt yield factors in long-term inflation expectations but clearly there is a disconnect with the compensation equity investors expect: the real required rate of return is more like 7.2 per cent based on the current share price. That could be to do with equity investors taking a more short-term view of inflation and perhaps thinking that NG's return on equity could be lower than in the past.

There are some big assumptions in the Gordon model, not least the constant dividend growth rate. We can quantify the impact of estimate changes by dividing the current dividend per share by an investor's required rate of return from the shares, and subtracting the result from the intrinsic value computed using the model.

All the inputs in the Gordon model are affected by the factors we have discussed. We recently broke down how the RoE measure used in the Gordon model is a product of profitability, efficiency and leverage. Having a better understanding of these variables makes for more confident, if still uncertain, forecasting of the benefit and utility expected from owning an income stock.

It's true that when 10-year UK government bonds are offering a risk-free yield of 3.5 per cent, the bar has been raised for more volatile assets like shares: a tough ask against the challenging economic backdrop. Investment-grade corporate credit should also pique the interest of income investors as, unlike dividends, coupons cannot be cut. That said, stock dividends are typically required to do most of the heavy lifting in generating payouts. So it’s always worth being on the lookout for good entry points for some of the most promising and reliable dividend payers.