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 ARM Holdings (LSE: ARM) (NASDAQ: ARMH.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
ARM Holdings is expected to carry a dividend of 5.6p per share in 2013, according to City estimates, with earnings per share forecast to come in at 20.8p. This results in dividend cover of 3.7 times, well above the generally-considered safety benchmark of 2 times prospective 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
ARM Holdings’ free cash flow registered at £119.2m in 2012, down substantially from £190.4m in 2011. Although operating profit climbed to £263m in the period from £222m in the prior 12 months, a massive movement in working capital of £80.7m saw cash flow deteriorate. The company was also affected by higher tax and capex costs last year.
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
ARM Holdings is a fantastic cash generator, and the balance sheet is not encumbered by debts or pension liabilities. This results in a negative net gearing ratio of 43.6% last year, versus 22.2% in 2011. Last year ARM Holdings produced net cash of £267.3m in 2012 against £203.8m in the prior 12 months.
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.
ARM Holdings does not engage in share repurchasing, nor does it have piles of debt which it needs to pay down. Instead, excess capital is used for research and development purposes to create the next generation of semiconductors.
A secure yet uninspiring dividend play
As the metrics above show, ARM Holdings is in solid financial shape, providing shareholders with excellent peace of mind for future dividend expansion. But for income investors the company continues to offer slim pickings.
Brokers expect the business to yield just 0.7% this year, well short of the FTSE 100 average of 3.3%. So although the company has steadily increased the payout in recent years — it raised the full-year payout almost 30% in 2012 — better income prospects can still be seen elsewhere.
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> Royston does not own shares in ARM Holdings.