Walking Through the Calculation of the Dividend Cushion Ratio
publication date: Mar 21, 2016
author/source: Brian Nelson, CFA
Shown: With brands such as Kleenex, Kimberly-Clark holds the No. 1 or No. 2 brand share in 80 countries; source: Kleenex.
This article is for educational purposes only to explain the nuts-and-bolts behind the calculation of the Dividend Cushion ratio. To access our updated opinion on Kimberly-Clark, please view its 16-page report and dividend report on its stock landing page. A version of this article appeared on our website July 3, 2013.
To read a more extensive academic white paper on the Dividend Cushion ratio, please download Valuentum's latest write up at the following link. Please select the link below:
Calculating the Dividend Cushion Ratio
We've received a significant amount of interest in the Dividend Cushion ratio, and we wanted to walk through the Dividend Cushion ratio calculation in depth for an example company, Kimberly Clark (KMB), in this article. This article is for educational purposes only.
Kimberly-Clark is a Dividend Aristocrat, meaning it has raised its dividend in each of the past 25+ years (40+ years in Kimberly Clark's case). The firm's dividend yield is above the ~2% average for S&P 500 companies, offering a 3.3% annual payout at recent price levels. We prefer annual dividend yields above 3% and generally don't include firms with yields below 2% in the Dividend Growth Newsletter portfolio, which we update monthly as a key component of the Dividend Growth Newsletter, released on the first of each month to members via email.
We think the safety of Kimberly-Clark's dividend is GOOD (please see our definitions of these qualitative assessments at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate significantly through the course of an economic cycle, so using the dividend payout ratio (dividends per share divided by earnings per share) in any given year has limitations. Plus, companies can often encounter unforeseen charges, which makes accounting (reported) earnings a less-than-predictable measure of the safety of the dividend.
We also know that companies won't cut the dividend just because earnings have declined or a firm had a restructuring charge that put it in the red for a quarter (or year or two). We therefore believe that assessing the forward-looking free-cash-flow and balance-sheet dynamics of a business, in conjuction with the firm's dividend payout ratio and other items, allows us to better determine whether a firm has the capacity to continue paying dividends (and how much capacity to keep growing the dividend) well into the future.
This forward-leaning line of thinking has led us to develop the forward-looking Valuentum Dividend Cushion ratio. The measure is a ratio that sums the existing net cash (total cash less total debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period. Basically, if the ratio is above 1, the company has the capacity to pay out its expected future dividends.
As income investors, however, we'd like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. At the time of the original publishing of this article, for Kimberly-Clark, the ratio is 1.3, revealing that on its current path the firm should be able to cover its future dividends (and the expected growth in them) with net cash on hand and future free cash flow over the measurement period.
Derivation of Kimberly-Clark's Dividend Cushion - $ mil
To arrive at the Dividend Cushion ratio, please divide the numerator ($8,984 billion) by the denominator ($7,122 billion) in the graph below. The numerator represents the sum of a firm's net cash position and its cumulative analyst-driven 5-year expected free cash flows, as measured by cash flow from operations less all capital spending. The denominator represents the sum of a firm's cumulative 5-year expected cash dividends paid.
A ratio of 1.3 for Kimberly-Clark can be considered GOOD. The higher the ratio above 1, the better. The difference between the numerator and denominator is the firm's 'total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks.' The difference represents the excess cash that can be applied to more dividend increases (above that which are forecast in the analysis) during the 5-year measurement period.
The following build in the graph below is a mapping of the firm's residual free cash flow after deducting both capital spending and cash dividends (and after considering net debt obligations). The build up below illustrates why Kimberly-Clark has a relatively 'slim' Dividend Cushion. The residual blue bar at the right of the chart, the difference between the numerator and the denominator in the above graph, is modest in the context of the firm's robust cash-flow-from-operating dynamics. Companies that have high Dividend Cushion ratios have a significantly larger 'blue bar.' They have significantly more excess cash that can be applied to future dividend increases. We tend to like equities that have large Dividend Cushion ratios, all else equal.
Derivation of Kimberly-Clark's Total Cumulative 5-year Forecasted Distributable Excess Cash after Dividends Paid, ex buybacks - $ mil
The chart immediately above shows that Kimberly-Clark has a significant amount of dividend obligations to pay out in the coming years relative to its future expected free-cash-flow generation over this time frame (the dividends paid is the fourth bar from the left and absorbs cash generated from operations, the first bar on the left). The above analysis at the time of original publishing considers a 6% annual future growth rate in the dividend, as shown on the front page of the firm's dividend report--meaning the analysis is forward-looking and considers growth expectations in the dividend. This is an important consideration -- the Dividend Cushion measures the safety and growth of the dividend payout above and beyond expected dividend growth rates.
We prefer firms that have a very large residual cash position over the next five years, or a very large measure of 'total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks' -- the blue bar in the graph immediately above. The companies with the largest 'blue bars' are the ones with the strongest future dividend-growth prospects. Investors should consider equities that have a good balance of a strong dividend yield that meets certain personal criteria and a strong Dividend Cushion ratio to capture both required income and dividend growth dynamics. These firms already have nice income streams but also have ones that may be poised for material expansion.
Now on to a discussion of the potential growth of Kimberly-Clark's dividend.
As mentioned above, the greater the "cushion," the greater capacity a firm has to raise the dividend. Such dividend growth analysis is not complete, however, until we consider management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If a) there have been no dividend cuts in 10 years, b) the company has had a nice growth rate in recent years, and c) the firm boasts a strong Dividend Cushion ratio, we'd rate its future potential dividend growth as EXCELLENT, which is the case for Kimberly-Clark. After all, in this case, the company is a Dividend Aristocrat--meaning it has raised its dividend in at least each of the past 25 years.
Capital preservation is also an important consideration for income investors, or for all investors for that matter. We therefore assess the risk associated with the potential for capital loss. The in-depth valuation analysis is primarly included in each firm's 16-page report, but we also provide the valuation conclusions in a firm's Dividend Report for convenience. In Kimberly-Clark's case, at the time of the original publishing of this article, we think the shares are fairly valued (the firm's price falls within our estimated fair value range), so the risk of capital loss is MEDIUM. If we thought shares were undervalued, the risk of capital loss would be LOW. In fact, under this valuation condition (i.e. a low risk of capital loss), Kimberly-Clark would likely find its way into either the Best Ideas portfolio or Dividend Growth portfolio.
Wrapping Things Up
The Dividend Cushion is a forward-looking ratio (with a numerator and a denominator). It tells investors how many times future free cash flow (cash from operations less capital spending) will cover future cash dividend payments after considering the net cash on the balance sheet, which is also a key source of dividend strength. It is purely fundamentally-based and driven from items taken directly from the financial statements. The Dividend Cushion ratio should be assessed at least quarterly and is a measure of health and safety of a company's dividend payout. Firms with high dividend yields and strong Dividend Cushion ratios are ones with relatively large income streams that are poised for continued expansion.
Note: Our assessment of Kimberly-Clark's dividend has been borderline between good/poor in the past few years due to its Dividend Cushion consistently being so close to our cutoff of 1.25 for good (see definitions below). The score is 1.26 at the time of the original publishing of this writing. Evaluating the numerical score can be a value-add for readers -- in addition to considering our qualitative 'word' assessment, definitions provided below.