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Wednesday, August 13, 2014

The Most Important Financial Statement When Selecting Dividend Growth Stocks

We all know what surprising the street will do to a stock's price. The street focuses on quarterly revenue, EPS, EBIT, EBITDA and margins. The income statement is where you find all the metrics that the street loves. Therefore, the income statement must be the most important financial statement... or is it?

In my opinion the most important financial statement is the lowly cash flow statement. Unfortunately, it is probably the least used and most misunderstood statement. Ultimately cash flow is what drives the value of any financial asset. The reason analysts look at revenue, EPS, EBIT, EBITDA and margins, they are trying to estimate a cash flow number.

The balance sheet is a snapshot of a company's financial position (assets and liabilities) at a single point in time, while the income statement summarizes a company's income and expenses over an interval of time to determine if a profit was earned. Both of these financial statements are prepared using accrual-basis accounting which matches revenues with the associated expenses to generate those revenues in the same period. This leads to a disconnect between cash and earnings.

For example, during the quarter a company sells some surplus land for cash. The attorney who handled the paperwork did not bill the company by the end of the quarter. Under U.S. accounting rules, you would record an expense on the income statement and a liability to pay the attorney on the balance sheet, although no cash has been paid. The balance sheet and income statement are not the best places to look when you want to understand what is going on with cash.

The cash flow statement is not based on accrual accounting, but instead is a cash-basis report focusing on inflows and outflows of cash. It adjusts out transactions that do not directly affect cash receipts and payments, such as adding depreciation back to net earnings. The cash flow statement allows investors to understand how a company's operations are running, where the cash is coming from and how it is being spent.

Transactions are categorized into the cash flow statement's three sections of operating, investing and financing activities. The accounting rules are very specific in defining what goes into each section, which ensures a degree of comparability between companies. Below is a short description of each section:

Operating activities measure cash generated from core business operations – the sale of the company’s products and services. Included here are income and costs associated with production, sales, delivery, as well as collecting cash from customers. Cash from operating activities should always be positive and greater than the company's net income. Earnings are considered "high quality" when operating cash flow is consistently greater than net earnings. If operating cash flow is less than net earnings, this is a strong signal you need to look deeper into the financials with a critical eye.

Investing activities focus on the purchase of the long-term assets the company needs to make and sell its products, along with any sales of long-term assets. This section also includes business acquisitions and strategic investments.

Financing activities include the inflow of cash from the sale of stock or issuance of debt, as well as the outflow of cash as dividends, purchases of treasury stock and repayment of debt.

When evaluating the sustainability of a company's dividend, I focus on Free Cash Flow. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section). For a business to remain viable, it must replace capital assets when they wear out. The next step is to compare Free Cash Flow with cash used to pay dividends. For that I calculate a Free Cash Flow Payout ratio.

The formula for Free Cash Flow Payout is simply Annual Dividend Per Share divided by Free Cash Flow Per Share. I like to see a percentage of 70% or less. The 70% is somewhat higher than many people look for with a traditional earnings-based payout ratio. I am comfortable with the higher number since we are talking about real cash generated from running the business vs. accounting earnings that may or may not be there. 

This week, I screened my dividend growth stocks database for stocks that have a Free Cash Flow Payout of 55% or less, have increased dividends for at least 25 consecutive years, rated 3-stars or better and have a yield in excess of 2.5%. The results are presented below:

Emerson Electric Co. (EMR) designs and supplies product technology, and delivers engineering services and solutions to a wide range of industrial, commercial and consumer markets around the world. The company has paid a cash dividend to shareholders every year since 1947 and has increased its dividend payments for 58 consecutive years.
Yield: 2.5% | 3-Star

Genuine Parts Co (GPC) is a leading wholesale distributor of automotive replacement parts, industrial parts and supplies, and office products. The company has paid a cash dividend to shareholders every year since 1948 and has increased its dividend payments for 58 consecutive years.
Yield: 2.6% | 4-Star

Johnson & Johnson (JNJ) is a leader in the pharmaceutical, medical device and consumer products industries. The company has paid a cash dividend to shareholders every year since 1944 and has increased its dividend payments for 52 consecutive years.
Yield: 2.7% | 4-Star

Brady Corp. (BRC) operates as an international manufacturer and marketer of identification solutions and specialty products which identify and protect premises, products and people. The company has paid a cash dividend to shareholders every year since 1984 and has increased its dividend payments for 29 consecutive years.
Yield: 2.7% | 3-Star

Sonoco Products Co. (SON) makes of paper and plastic packaging products serves various industries and markets in more than 85 countries. The company has paid a cash dividend to shareholders every year since 1925 and has increased its dividend payments for 31 consecutive years.
Yield: 2.9% | 3-Star

Community Trust Bank Corp. (CTBI) owns and operates Community Trust Bank, Inc. of Pikeville, KY, which provides commercial banking services in Kentucky and West Virginia; and a trust company. The company has paid a cash dividend to shareholders every year since 1988 and has increased its dividend payments for 34 consecutive years.
Yield: 3.3% | 3-Star

Cincinnati Financial Corp. (CINF) is an insurance holding company that primarily markets property and casualty coverage. It also conducts life insurance and asset management operations. The company has paid a cash dividend to shareholders every year since 1954 and has increased its dividend payments for 54 consecutive years.
Yield: 3.6% | 3-Star

Old Republic Intl (ORI) is an insurance holding company that engages mainly in the general (property and liability), title, and mortgage guaranty and consumer credit indemnity run-off businesses. The company has paid a cash dividend to shareholders every year since 1942 and has increased its dividend payments for 33 consecutive years.
Yield: 4.3% | 4-Star

Conclusion:

As an investor, you want to pay close attention to the cash flow statement. Given the complexity of today’s accounting rules, earnings on the income statement and assets and liabilities on the balance sheet are often misleading (e.g. mark-to-market of a derivative, recording an asset for an asset retirement obligation).

When a company consistently generates more cash than it uses, it will be able to increase dividends paid, buy back shares, reduce debt, or acquire another company. As a dividend investor, I want to know my company is financially capable of paying me a higher dividend each year, and the cash flow statement is the first place to look when making this determination.

How do you use the cash flow statement when evaluating a company?

Full Disclosure: Long GPC, JNJ, EMR, CTBI, CINF in my Dividend Growth Portfolio. See a list of all my dividend growth holdings here.

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Tags: [GPC] [JNJ] [EMR] [BRC] [SON] [CTBI] [CINF] [ORI]

1 comment:

  1. I much prefer to look at the cash flow statement and use that more than anything to determine the sustainability and the ability to grow the dividend in the future. Thanks for the overview of the different financial statements.

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