The ability to calculate the reliability of dividends is absolutely crucial for investors, not only for evaluating the income generated from your portfolio, but also to avoid a share-price collapse from stocks where payouts are slashed.
There are a variety of ways to judge future dividends, and today I am looking at Rio Tinto (LSE: RIO) (NYSE: RIO.US) to see whether the firm looks a safe bet to produce dependable payouts.
Forward dividend cover
Forward dividend cover is one of the most simple ways to evaluate future payouts, as the ratio reveals how many times the projected dividend per share is covered by earnings per share. It can be calculated using the following formula:
Forward earnings per share ÷ forward dividend per share
Rio Tinto is on course to deliver a dividend of 118.8p in 2013, according to broker estimates, with earnings per share of 338p also expected for this year. This results in dividend cover of 2.8 times earnings, easily surpassing the safety benchmark of 2 times.
Free cash flow
Free cash flow is essentially how much cash has been generated after all costs and can often differ from reported profits. Theoretically, a company generating shedloads of cash is in a better position to reward stakeholders with plump dividends. The figure can be calculated by the following calculation:
Operating profit + depreciation & amortisation – tax – capital expenditure – working capital increase
Rio Tinto saw free cash flow shuttle to a negative reading of $1.92bn last year, shifting from a positive cash flow of $11.7bn in 2011. Operating profit dipped substantially in 2012, to $12.46bn from $22.92bn, while capex costs also advanced to $17.42bn from $12.3bn.
Substantial working capital movements also prompted the deterioration — this increased $974m last year against a $3.7bn decrease in 2011. And a vastly reduced tax bill, to $429m from $6.44bn, failed to stop the huge cash flow deterioration.
Financial gearing
This ratio is used to gauge the level debt a company carries. Simply put, the higher the amount, the more difficult it may be to generate lucrative dividends for shareholders. It can be calculated using the following calculation:
Short- and long-term debts + pension liabilities – cash & cash equivalents
___________________________________________________________ x 100
Shareholder funds
Rio Tinto’s gearing ratio came in at 62.4% last year, up significantly from 52.9% in 2011. Total debt increased to $26.82bn from $21.8bn, more than offsetting a fall in pension liabilities. And cash and cash equivalents fell to $7.22bn from $9.65bn. A drop in shareholder funds, to $58.02bn from $59.21bn, also increased the gearing ratio, albeit not substantially.
Buybacks and other spare cash
Last year’s heavy losses, combined with a murky outlook for global commodities demand and rising costs, has forced Rio Tinto to embark on a severe cost-cutting drive. This includes shelving a number of expansion and start-up projects for the coming years, and in 2013 the firm expects to spend just £13bn on capital expenditure.
And the company is also seeking to sell off more of its non-core assets in its desire to push the balance sheet back into rude health. The firm cancelled the sale of its diamonds division last month, although a number of its other assets remain on the chopping block — indeed, Rio Tinto sold off its Eagle nickel-copper project in the US in June.
Battered financials and gloomy outlook present a gamble
Rio Tinto provides a dividend yield of 4.1% in 2013, comfortably above the FTSE 100 prospective average of 3.3%. The company has steadily rebuilt the full-year dividend after cutting the payout some 60% in the aftermath of the 2008/2009 global recession and subsequent hit to commodity prices.
However, investors should be aware that — like all mining companies — Rio Tinto, with its heavily beleaguered balance sheet, is a classic high risk, high reward play. As a consequence, fresh dividend volatility could be in the offing should further earnings weakness come to fruition.
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> Royston does not own shares in Rio Tinto.
