Investing Club mailbag: How to tell if a company will keep paying its dividend

Published Sun, Feb 12 20234:48 PM EST

How do we figure out free cash flow and how can we tell if a company can continue to pay its dividend. -David E. This is a great question and fortunately a pretty straightforward one to answer using some quick and simple math. Free cash flow is a popular metric for analysts and investors because it shows how much money a company can give back to shareholders. However, it is not actually a GAAP metric — "generally accepted accounting principles" — which means companies don't have to disclose the figure and also don't always agree on exactly how to define it. Generally, free cash flow is defined as operating cash flow minus capital expenditures or cash used for the purchases of plant, property and equipment (PP & E). Companies that don't follow GAAP might report this as a line item in their quarterly and annual reports. Some, like Alphabet (GOOGL), report GAAP numbers but also provide a non-GAAP free-cash-flow calculation. For those that don't provide it, you need to calculate the metric. First find operating cash flow (OCF) and PP & E , which are both in the cash flow statement ; OCF is its own line, PP & E is under "investing cash flows." Then subtract the cash related to PP & E from OCF. Take Apple, a Club holding that uses GAAP and therefore doesn't break out free cash flow. Operating cash flow for the quarter ended Dec. 31, 2022 was $34.005 billion and payments for the acquisition of property, plant and equipment were $3.787 billion, resulting in a free cash flow of $30.218 billion (34.005-3.787=30.218). Why free cash flow is important For starters, free cash flow is a more conservative metric than operating cash flow, given that it takes into account the cash associated with PP & E — money that can't be used to pay shareholders through buybacks or dividends. Companies need ongoing investments in PP & E — Amazon improving its delivery system or Microsoft putting money into its cloud infrastructure — but removing those costs from OCF gives a much clearer picture of the cash left over for investors. Secondly, free cash flow can help determine the quality of a company's earnings. There are many perfectly legal, GAAP-approved ways to calculate an earnings number, based on management's classification of certain items or simply how it goes about realizing revenue. But free cash flow is cash: you either received it or you didn't. And cash is king. If the earnings are backed by cash received, they are viewed as higher quality than non-cash-backed earnings. Lastly — and this brings us to the second part of the David's question — free cash flow can be compared to other financial obligations requiring cash to determine if those obligations can be met. There may be cash on the balance sheet, but if cash outflows exceed cash inflows (in this case defined as free-cash-flow generation), that cash balance is going to decline over time and eventually run out. Without a reversal, it will take the company out as well. One such obligation would be the dividend. A company can cut its dividend without any legal consequences, but it will certainly matter to those invested in the stock for dividend income. Therefore, a study of the company's ability to keep paying the dividend is crucial. The math is once again straightforward: If the free cash inflow exceeds the cash dividend outflow, it is considered sustainable. The greater the surplus, the stronger the margin of safety. You can't glean this from one earnings report. Instead, a look at the annual financial releases going back a few years will show the volatility of cash flows over time (and help smooth out the quarter-to-quarter volatility). There may be periods in which the dividend payment exceeds free cash flow. That's ok so long as it isn't a recurring thing; cash on the balance sheet can serve as a temporary buffer. Consider the last 10 years of dividends, OCF and FCF on a per-share basis for Procter & Gamble (PG), according to data from FactSet. With the exception of fiscal year 2013 (FY 2013) and fiscal year 2015, free cash flow consistently outpaces dividends payments. Moreover, given the nature of Procter & Gamble products — household staples that require consistent replenishment — and status as an industry leader, we're confident it can keep generating cash flows into the foreseeable future. We also included the company's per-share OCF. It's always good to think about dividend sustainability in a few ways. With OCF, it's possible the company could delay or cut back on some investments (PP & E) to free up more cash for pressing obligations, like paying a dividend. Many analysts will cite the dividend payout ratio as a means of determining a dividend's sustainability. The formula is simple: divide the dividend payout by net income (or earnings if you are doing it on a per-share basis). If the result exceeds 100%, indicating that the dividend is greater than net income, the dividend is considered unsustainable. After all, you can't keep paying out more than you take in. If it's less than 100% it's considered sustainable. The dividend payout ratio is certainly a metric worth considering. However, earnings backed by cash are higher quality. So in addition to calculating the dividend payout ratio, consider the extent to which the earnings are backed by cash. A company can't pay out its dividend in IOUs, which may be a large component of net income depending on the company. Those IOUs would be logged in the accounts receivables portion of the balance sheet, instead of as cash. One final consideration is the concept of variable dividends. Many of our holdings offer up a fixed-plus-variable dividend, with the variable portion tied directly to free cash flow. For example, a company will state it intends to pay out some portion of free cash flow via dividends and/or buybacks. With this framework, we again see the importance of free cash flow and its sustainability since the variable portion of the dividend will fluctuate with the cash flow. Energy companies often use fixed-plus-variable dividends, since their cash flows will fluctuate with the swings in the price of crude oil. Have a question or topic you would like to see us discuss in our next white paper? E-mail us at cnbcinvestingclub@cnbc.com or tweet me @ZevFima . (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. 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Pampers Diapers, which are manufactured by Procter & Gamble, are displayed in an Associated Supermarket in New York.

Ramin Talai | Bloomberg | Getty Images

How do we figure out free cash flow and how can we tell if a company can continue to pay its dividend.

-David E.