The worth of a business, any business, distils down to the cash it produces or the potential it has to generate cash in the future.
It also takes hard cash to pay a dividend, and those reasons are why I like to focus on cash generation when appraising a firm’s ability to generate an income for its investors.
Cash and debt
I keep an eye on a company’s debt levels, too, and how the firm is managing its borrowings. Are they rising, falling, flat or maybe there’s a net cash position on the balance sheet. Why is debt so important? Because it competes with investors for the cash that a firm generates. If debt gets too high, a company pays lots of money to pay the interest and that cash is then not available to pay dividends.
Sometimes, companies seem to pay dividends even if the debt is high and even if they don’t really have the money left over after paying interest and reinvesting capital into the business to maintain operations. When that happens, debts tend to keep rising even though the firm might not be growing. When we see that kind of situation, it’s a big red flag to steer clear because, if nothing changes, events will likely conspire to compromise the firm’s ability to maintain dividend progression, or even to maintain the dividend at its artificially inflated level.
If we are holding shares in a company that trims its dividend, chances are high that we’ll lose both dividend income and suffer a capital loss as the share price falls to adjust for the lower value then apparent in the underlying business.
The news is good
That’s why I’m pleased to see fixed-line telecoms company BT Group (LSE: BT-A) (NYSE: BT.US) report free cash flow up a bit and net debt down a bit with its recent first-quarter update.
In recent years, the firm achieved stable figures for both cash flow and borrowings:
| Year to March | 2010 | 2011 | 2012 | 2013 | 2014 |
| Net cash from operations (£m) | 4,825 | 4,566 | 3,558 | 5,295 | 4,796 |
| Net borrowings (£m) | 11,339 | 9,505 | 10,155 | 9,089 | 9,119 |
In earlier guidance, BT said it expects revenues to come in flat this year with further growth the year after. Earnings should be up a little in the current year with growth during 2015. Cash flow, however, will be up both this year and next. The firm’s performance in quarter one shows things are on track.
If cash flow keeps improving through the year, as BT expects, I’ll be looking for further progress on debt reduction, too. We’ll find out more with the interim results due on 31 October.
Growth in operations
BT puts much of its good financial performance down to its investment in fibre optic services. The fibre broadband network covers more than twenty million premises, around two-thirds of Britain, and is expanding at a rate of around 70,000 additional premises each week the firm says.
Although the UK provides most of BT’s profits, the firm operates in more than 170 regions abroad, with the Global Services division delivering around a third of revenues. If profits abroad catch up with revenues, there’s potential for BT to realise its aim to become a global leader in its field, which could deliver useful growth to keep the dividend building.
BT’s dividend record is encouraging:
| Year to March | 2010 | 2011 | 2012 | 2013 | 2014 |
| Dividend per share | 6.9p | 7.4p | 8.3p | 9.5p | 10.9p |
At a share price of 390p, BT trades with a forward P/E rating just over 12 for 2016. The forward dividend yield is 3.7% and City analysts expect earnings to grow 8% that year and cover the payout more than twice.
BT seems set to continue to benefit from a rapidly digitalising world, and the firm’s market valuation appears modest given its potential for growth abroad and in the home market.
