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 Diageo (LSE: DGE) (NYSE: DEO.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
Diageo’s preliminary results for the year ending June 2013 are due on Wednesday, 31 July, and the company is expected by City brokers to produce a 47.3p per share dividend.
For 2014, the drinks giant is anticipated to provide a 51.7p per share payout, with earnings per share of 112.8p pencilled in for this period. These figures generate dividend cover of 2.2 times, ahead of the safety benchmark of 2 times earnings.
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
Diageo saw free cash flow dip to £2.07bn in 2012, down fractionally from a reading of £2.1bn in the previous year. Operating profit advanced to £3.16bn last year from £2.6bn in 2011, while depreciation and amortisation also improved on an annual basis. Still, working capital increased to £529m in 2012 from £110m in 2011. Capital expenditure and tax also increased markedly.
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
Diageo saw gearing edge come in at 137.7% last year, down from 159.9% in 2011. Net debt fell to £6.61bn from £7.55bn year-on-year, substantially offsetting a rise in the pension liability. An increase in shareholder equity, to £5.59bn from £5.25bn, also heralded an improvement in the ratio.
Buybacks and other spare cash
Here, I’m looking at the amount of cash recently spent on share buybacks, repayments of debt and other activities that suggest the company may in future have more cash to spend on dividends.
Diageo has not been shy in committing capital to acquisition activity in recent years. Moves into China and Brazil — through white-spirit maker Shui Jing Fang and rum manufacturer Ypioca respectively — illustrate the firm’s desire to expand in lucrative developing regions. And the company secured an additional 14.98% in Indian spirits giant United Spirits last week, taking its total stake to more than 25%.
A secure if unspectacular dividend selection
I believe that the metrics discussed above suggest that Diageo provides the financial stability so prized by dividend hunters. However, Diageo is expected in 2014 to provide a dividend yield of 2.6%, far below the 3.3% prospective average of the FTSE 100.
The company has a solid record of implementing annual dividend increases as earnings have reliably improved, and further positive growth projections suggest that shareholder payouts should keep on growing. But it could be argued that yields are currently not appetising enough to attract die-hard income investors.
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> Royston does not own shares in Diageo.