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 BP (LSE: BP) (NYSE: BP.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
BP is expected to produce a dividend of 23.6p per share in 2013, according to City estimates, while earnings per share are predicted to come in at 54.4p. This provides dividend cover of 2.3 times prospective earnings, providing decent breathing space above the safety threshold 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
BP posted negative free cash flow of $9.42bn in 2012, worsening from a negative readout of $2.46bn in the previous year. Operating profit dropped to $26.42bn from $33.6bn, the firm having to undergo severe divestment activity following the 2010 Deepwater Horizon oil spill, which whacked production levels. A working capital increase of $17.53bn versus $7.65bn also caused the deterioration.
Capex spend dropped to $24.34bn from $31.52bn, however, as the potential cost of the Gulf of Mexico crisis crimped outlay.
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
The oil giant’s gearing ratio registered at 25.2% last year, down from 27.7% in 2011. Although total debt rose to $48.8bn in 2012 from $44.21bn, this was more than offset by a leap in cash and cash equivalents — this rose to $19.55bn from $14.07bn. Instead, an increase in shareholders’ equity, to $119.62bn from $112.48bn in 2011, was the driving factor behind the lower gearing in 2012.
Buybacks and other spare cash
BP continues to churn out extra cash for its investors through its share repurchasing programme, and is on the path to returning $8bn to shareholders following the sale of its 50% holding in TNK-BP in March to Rosneft.
In addition, the oil firm said that it expects asset sales following the Deepwater incident to slow from next year onwards. BP says that investments should come in at between $24bn and $27bn from next year onwards, up from its target of between $24bn and $25bn at present.
Risks remain despite lucrative dividend projections
Dividend projections for BP in the medium term are attractive, and analysts expect BP to provide a dividend yield of 5.2% in 2013, a massive improvement on the prospective FTSE 100 average of 3.3%.
However, I believe that the company remains a risky pick for income investors as continued legal action — allied to the possibility of fresh oil price volatility — threatens to further unbalance the firm’s financial stability.
Although the company expects the final bill for the Gulf of Mexico crisis to come in around $42.2bn, legal action is ongoing and is unlikely to be completed anytime soon. At the same time, the company is also being investigated for alleged oil-price rigging along with Royal Dutch Shell, which could result in further heavy financial penalties.
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> Royston does not own shares in any of the companies mentioned in this article.
