When I analyze the safety of a dividend, I look at several different things. The track record is critical.
If a company raises the dividend every year, management has made it clear that the dividend is important. If it cuts the dividend, it’s expressed that the dividend is not a priority.
I also look at cash flow.
[ad#Google Adsense 336×280-IA]Does the company have the ability to pay the dividend based on cash flow?
Earnings are nice. But net income has all kinds of noncash items included in its calculation.
Cash flow represents how much cash the company takes in.
When cash flow is much higher than the dividend, you know that even if things get difficult, the company should have no problem paying its dividend.
With that, let’s put these metrics to use.
As requested, this week we’re looking at a tech giant that pays a respectable 3.1% yield.
It wasn’t that long ago that Microsoft (Nasdaq: MSFT) was a high-flying tech stock. Today, the software company is stable, with high single-digit earnings growth.
The company has raised its dividend every year since 2010 by at least 10% per year. Before that, it boosted the dividend in 2006, 2007 and 2008. During the financial crisis, it left the dividend unchanged for two years.
Microsoft has plenty of cash, with $62 billion of net cash in the bank. (Net cash is cash minus debt.) The company has $28 billion in debt with $90 billion in cash. So its debt is not a concern at all.
Over the past four quarters, Microsoft generated $27 billion in free cash flow. During that period, it paid out $9.5 billion in dividends for a payout ratio of just 35%. In other words, it pays out $0.35 of every dollar of free cash flow. That is quite low.
I like companies to have payout ratios of 75% or lower. That way, if times get tough, there is a buffer and they won’t have to cut their dividends. Think of it this way – if a company’s cash flow is $1 billion and it pays out $1 billion in dividends, what happens next year if cash flow falls to $800 million?
The company would either have to pay the other $200 million in dividends from cash on hand, borrow the money, raise the money by selling stock or cut the dividend.
If the same company started off paying $750 million, the 20% drop in free cash flow wouldn’t jeopardize the dividend.
So Microsoft’s 35% payout ratio gives it plenty of wiggle room in a down economy.
In fact, with so much cash in the bank, I’d like to see Microsoft continue to raise the dividend, but by a more substantial amount. It could easily pay out half its free cash flow in dividends and not have to worry about it.
This fiscal year, which ends in June, Wall Street forecasts Microsoft’s free cash flow to be $23.5 billion, rising to $25.4 billion next fiscal year.
Even if the company increases the dividends paid by 15% for each of the next two years, in fiscal 2016, it would pay out $11.7 billion, which is still well below 50% of expected free cash flow.
Microsoft likely has at least several years of double-digit dividend growth ahead of it if management continues to reward shareholders.
I wish every dividend company that I analyzed looked like Microsoft. It has huge sacks of cash sitting in the bank, double-digit annual dividend increases and more than enough free cash flow to fuel the dividend truck for years to come.
Microsoft’s dividend is about as secure as it gets.
Dividend Safety Rating: A
Good investing,
Marc
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Source: Wealthy Retirement