If youre looking for dividends, there arethose with staying power from companies with robust business and financial achievements. Or there are more fragiledividends that arise because of weaker operational and financial characteristics. Those should be avoided even though theirhigh dividend yields can be tempting. But how to tell the difference?
Lets look atthree FTSE 100 firms: Royal Bank of Scotland Group (LSE: RBS), JSainsbury (LSE: SBRY) and British American Tobacco (LSE: BATS).
Theyoperate in different sectors, but all look set to pay a dividend for 2016. At the recent share price of 234p, Royal Bank of Scotlands forward yield for 2016 should be 0.5%. At 246p, J Sainsburys is around 4.3%. At 3765p, British American Tobaccos is 4.4%.
Here are some tests gauging business and financial quality, and scoring performance in each test out of a maximum five.
-
Dividend record
Here are the firms dividend records:
|
Ordinary dividends |
2011 |
2012 |
2013 |
2014 |
2015 |
|
Royal Bank of Scotland |
0 |
0 |
0 |
0 |
0 |
|
J Sainsbury (pence) |
16.1 |
16.7 |
17.3 |
13.2 |
10.74(e) |
|
British American Tobacco (pence) |
126.5 |
134.9 |
142.4 |
148.1 |
156.21(e) |
RBS paid zero dividends over the period. Sainsbury sawa dividend contraction of 33% and BAT boosted itsdividend by 23% soIm scoring RBS0/5, Sainsbury 1/5, and BAT4/5.
-
Dividend cover
RBSexpects forward earnings to cover its modest dividend in 2016 almost 20 times. Sainsbury expects earnings to cover its dividend payout just over twice, and BATanticipates cover around 1.35 times.
I feelearnings shouldcover the dividend payout at least twice in my dividend investments, but as cash pays dividends, digdeeper into how well (or poorly) these companies cover their dividend payouts with free cash flow too.
On dividend cover from earnings, Im awarding RBS5/5, Sainsbury 4/5, and BAT2/5.
-
Cash flow
Dividend cover from earnings means little if cash flow doesnt support profits.
Here are the companies recent records on operational cash flow compared to profits:
|
2010 |
2011 |
2012 |
2013 |
2014 |
|
|
Royal bank of Scotland |
|||||
|
Operating profit (m) |
(399) |
(766) |
(5,277) |
(8,243) |
2,643 |
|
Net cash from operations (m) |
19,291 |
3,325 |
(45,113) |
(30,631) |
(20,387) |
|
J Sainsbury |
|||||
|
Operating profit (m) |
851 |
874 |
882 |
1,009 |
81 |
|
Net cash from operations (m) |
854 |
1,067 |
981 |
939 |
911 |
|
British American Tobacco |
|||||
|
Operating profit (m) |
4,318 |
4,721 |
5,372 |
5,526 |
4,546 |
|
Net cash from operations (m) |
4,490 |
4,566 |
4,427 |
4,436 |
3,716 |
Royal Bank of Scotlands record of profits and cash flow looks disastrous. When cash flow fails to support profits, firms must make up the shortfall elsewhere, such as investing or fundraising. Such reliance on activities other than straightforward banking is part of what makes banks such as RBScyclical and prone to the volatility that exaggerates macroeconomic and financial market wobbles.
Meanwhile, Sainsbury displays robust positive cash flow that supports profits, and BATsperformance on cash generation is steady, despitea trend towards cash flow lagging operating profits.
Im playing safe, scoring RBS0/5 for its record on cash flow from operations. Sainsbury gets 5/5 and BAT3/5.
-
Debt
Interest payments on borrowed money compete with dividend payments for incoming cash flow, making big debts undesirable in dividend-led investments.
RBSsexternal borrowings are at least 10 times 2015s pre-tax profits and maybe more. Sainsburys gross debt runs at around 3.7 times 2015s pre-tax profit and BATsat 2.75 times profits for 2015.
Most banks carry big debts. Arguably banking businesses require (and can justify) high debt loads. But I reckon banks would make more secure investments with lower levels of borrowing. Indeed, the need for high exposure to debt in order to turn a profit seems to be a keyreason banks get in trouble when economies tank.
Im awarding RBS0/5, Sainsbury 2/5, and BAT3/5 for their approach to borrowings.
-
Degree of cyclicality
Recent weakness inshare prices of banks and commodity firms teaches me not to become complacent about their inherent cyclicality.
Cyclical firms make poor choices for dividend-led investors and RBSoperates with hair-trigger cyclical characteristics. And whileinvestors once prized supermarkets for stability and lack of cyclicality, Sainsbury currently faces a discounter-led structural challenge to itsindustry that could see the firm in long-term decline.
BAThas almost zero cyclicality due to its product consumable goods with addictive qualities.
Im scoring RBS1/5, Sainsbury 4/5, and BAT5/5 for cyclicality.
Putting it all together
Here are the final scores:
|
Royal Bank of Scotland |
J Sainsbury |
British American Tobacco |
|
|
Dividend record |
0 |
1 |
4 |
|
Dividend cover |
5 |
4 |
2 |
|
Cash flow |
0 |
5 |
3 |
|
Debt |
0 |
2 |
3 |
|
Degree of cyclicality |
1 |
4 |
5 |
|
Total score out of 25 |
6 |
16 |
17 |
BATwins here but none of the trio are perfect by these measures, so I continue to seeka dividend champion.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
