Tuesday, December 26, 2017

The Most Important Financial Statement When Selecting Dividend Growth Stocks

We all know what surprising the street will do to a stock's price. The street focuses on quarterly revenue, EPS, EBIT, EBITDA and margins. The income statement is where you find all the metrics that the street loves. Therefore, the income statement must be the most important financial statement... or is it?

In my opinion the most important financial statement is the lowly cash flow statement. Unfortunately, it is probably the least used and most misunderstood statement. Ultimately cash flow is what drives the value of any financial asset. The reason analysts look at revenue, EPS, EBIT, EBITDA and margins, they are trying to estimate a cash flow number.

The balance sheet is a snapshot of a company's financial position (assets and liabilities) at a single point in time, while the income statement summarizes a company's income and expenses over an interval of time to determine if a profit was earned. Both of these financial statements are prepared using accrual-basis accounting which matches revenues with the associated expenses to generate those revenues in the same period. This leads to a disconnect between cash and earnings.

For example, during the quarter a company sells some surplus land for cash. The attorney who handled the paperwork did not bill the company by the end of the quarter. Under U.S. accounting rules, you would record an expense on the income statement and a liability to pay the attorney on the balance sheet, although no cash has been paid. The balance sheet and income statement are not the best places to look when you want to understand what is going on with cash.

The cash flow statement is not based on accrual accounting, but instead is a cash-basis report focusing on inflows and outflows of cash. It adjusts out transactions that do not directly affect cash receipts and payments, such as adding depreciation back to net earnings. The cash flow statement allows investors to understand how a company's operations are running, where the cash is coming from and how it is being spent.

Transactions are categorized into the cash flow statement's three sections of operating, investing and financing activities. The accounting rules are very specific in defining what goes into each section, which ensures a degree of comparability between companies. Below is a short description of each section:

Operating activities measure cash generated from core business operations – the sale of the company’s products and services. Included here are income and costs associated with production, sales, delivery, as well as collecting cash from customers. Cash from operating activities should always be positive and greater than the company's net income. Earnings are considered "high quality" when operating cash flow is consistently greater than net earnings. If operating cash flow is less than net earnings, this is a strong signal you need to look deeper into the financials with a critical eye.

Investing activities focus on the purchase of the long-term assets the company needs to make and sell its products, along with any sales of long-term assets. This section also includes business acquisitions and strategic investments.

Financing activities include the inflow of cash from the sale of stock or issuance of debt, as well as the outflow of cash as dividends, purchases of treasury stock and repayment of debt.

When evaluating the sustainability of a company's dividend, I focus on Free Cash Flow. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section). For a business to remain viable, it must replace capital assets when they wear out. The next step is to compare Free Cash Flow with cash used to pay dividends. For that I calculate a Free Cash Flow Payout ratio.

The formula for Free Cash Flow Payout is simply Annual Dividend Per Share divided by Free Cash Flow Per Share. I like to see a percentage of 70% or less. The 70% is somewhat higher than many people look for with a traditional earnings-based payout ratio. I am comfortable with the higher number since we are talking about real cash generated from running the business vs. accounting earnings that may or may not be there. 

This week, I screened my dividend growth stocks database for stocks that have a Free Cash Flow Payout of 55% or less, have increased dividends for at least 25 consecutive years, rated 3-stars or better and have a yield in excess of 2.5%. The results are presented below:

Bunge Limited (BG) is a large, geographically diverse agribusiness and food company. The company has paid a cash dividend to shareholders every year since 1942 and has increased its dividend payments for 32 consecutive years.
Yield: 2.7% | 4-Star

Cincinnati Financial Corp. (CINF) is an insurance holding company that primarily markets property and casualty coverage. It also conducts life insurance and asset management operations. The company has paid a cash dividend to shareholders every year since 1954 and has increased its dividend payments for 57 consecutive years.
Yield: 2.7% | 3-Star

Archer-Daniels-Midland Co. (ADM) is one of the world's leading agribusiness concerns, with major market positions in agricultural processing and merchandising. The company has paid a cash dividend to shareholders every year since 1927 and has increased its dividend payments for 42 consecutive years.
Yield: 3.2% | 4-Star

Weyco Group, Inc. (WEYS) designs and markets footwear for men, women and children under various brand names, including Florsheim, Nunn Bush, Stacy Adams, BOGS, Rafters and Umi. The company has paid a cash dividend to shareholders every year since 1935 and has increased its dividend payments for 36 consecutive years.
Yield: 3.2 | 4-Star

Target Corp. (TGT) operates nearly 1,800 Target, SuperTarget and CityTarget general merchandise stores across the U.S. The company has paid a cash dividend to shareholders every year since 1965 and has increased its dividend payments for 50 consecutive years.
Yield: 4.0 | 3-Star

Mercury General Corp. (MCY), operating primarily in California, writes a full line of automobile coverage for all classifications of risk. The company has paid a cash dividend to shareholders every year since 1986 and has increased its dividend payments for 29 consecutive years.
Yield: 4.8 | 3-Star

Conclusion:

As an investor, you want to pay close attention to the cash flow statement. Given the complexity of today’s accounting rules, earnings on the income statement and assets and liabilities on the balance sheet are often misleading (e.g. mark-to-market of a derivative, recording an asset for an asset retirement obligation).

When a company consistently generates more cash than it uses, it will be able to increase dividends paid, buy back shares, reduce debt, or acquire another company. As a dividend investor, I want to know my company is financially capable of paying me a higher dividend each year, and the cash flow statement is the first place to look when making this determination.

How do you use the cash flow statement when evaluating a company?

Full Disclosure: Long CINF, MCY. See a list of all my Dividend Growth Portfolio holdings here.

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