A recent article I published on the safety of Verizon’s dividend garnered a lot of interesting discussion.
I did my best to dissect the company’s statement of cash flows to show why I believe Verizon’s dividend will remain safe, even despite the steep drop it reported in free cash flow last year (Verizon’s reported free cash flow in 2016 was not enough to cover the dividend).
Even despite my accounting background, it was a bit of a grueling exercise to get to the bottom of Verizon’s free cash flow decline and address the scary-looking spike in the company’s free cash flow payout ratio.
One of our members sent me an email after reading through my Verizon article, asking me the following question:
“If I see apparently-cautionary stats like a spike in the payout ratio, and a sudden decline in free cash flow per share, but the Dividend Safety Score is high, do I ignore my instincts to avoid the stock, or do I assume that you have dug deeper as in this analysis of Verizon, and place (blind) faith in the high safety score?”
I thought his question was excellent and wanted to share my response below:
“I think your comment resonates with many readers – how do you know if an apparently-cautionary statistic is noise or news? Does an indicator like a Dividend Safety Score pick it up? Can blind faith ever really exist these days? What can I do?
First, I would say that no indicator should ever warrant blind faith, although I will keep doing everything I possibly can to continue pushing our Safety Scores toward that threshold.
Our Dividend Safety Scores do try to distinguish noise from news in cases like Verizon, but the odd issues that can come up mean that our scores won’t always catch everything (nothing can).
With that said, here is what I like to do (and what our scores try to do). If you see an apparently-cautionary stat like Verizon’s FCF payout ratio, I first like to compare it to the company’s long-term history.
In Verizon’s case, its FCF payout ratio in 2016 is massively different than the firm’s payout ratio dating back to 2005. While there’s a chance this could be a real concern, odds are probably against that being the case.
To gain more confidence, I would take a look at sales growth next (sales tend to be less noisy, although they can be affected by acquisitions, divestitures, and foreign currency exchange rates).
Verizon’s revenue declined by 4% in 2016, but I wouldn’t expect this moderate decrease to cause such a spike in the FCF payout ratio, leading me to increasingly believe the spike is more noise than news.
If Verizon was experiencing real cash flow problems, analysts’ earnings estimates for the company would likelybe declining, too. You can check here (or perhaps on FastGraphs) to quickly see that Verizon’s earnings are expected to be stable to increasing over the next few years.
This probably wouldn’t be the case if there was a real cash flow issue at the company.
Finally, the market is pretty smart. For a mature, high dividend, heavily-indebted firm like Verizon, investors would have begun to price in a dividend cut if 2016 free cash flow as really a problem. Verizon’s dividend yield would almost certainly be well in excess of 5% rather than the 4.7% yield it has today.
The market can definitely be wrong sometimes, but it’s usually quite efficient. So, to summarize, I would never trust anything blindly. I know it’s not a perfect checklist, but I like to take the following steps:
1) Compare the most recent “apparently-cautionary” statistic to the company’s long-term results – does it look really unusual?
2) Take a look at one or two less noisy indicators, such as sales growth, to see if it looks like the company’s “operational” results actually experienced a big hit, which could warrant real caution.
3) Look at what analysts’ are projecting over the next couple of years (are things actually getting worse?) and see what the market is telling you with the stock’s performance and yield.”
Dealing with apparently-cautionary statistics, such as Verizon’s 2016 free cash flow, can be uncomfortable and involve a good deal of uncertainty in many cases.
However, doing a little poking around by reviewing a small set of additional indicators can help you quickly build a clearer picture of what’s actually going on in many cases, reducing the temptation to make knee-jerk reactions to surprising data.
Perhaps more importantly, learning how to conduct a basic “financial audit” in these situations will help you become a more effective dividend investor.
You will be able to make better informed decisions and gain more control of your decision-making process, reducing your potential “blind faith” dependence on the many talking heads and “proprietary” indicators out there.
At a minimum, there are a handful of financial metrics that I think every dividend investor should know (review them here) to become more empowered and make more responsible investment decisions.
After all, Warren Buffett has said you should “take all the accounting courses you can find. Accounting is the language of business…It’ll make it so much easier for years and years to come for reading financial statements, to get comfortable with it, because it is a language all of its own. Getting comfortable in a foreign language takes a little experience, a little study early on, but it pays off big later on.”