The ability to calculate the reliability of dividends is absolutely crucial for investors, not only for evaluating the income generated from your portfolio, but also to avoid a share-price collapse from stocks where payouts are slashed.
There are a variety of ways to judge future dividends, and today I am looking at Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) to see whether the firm looks a safe bet to produce dependable payouts.
Forward dividend cover
Forward dividend cover is one of the most simple ways to evaluate future payouts, as the ratio reveals how many times the projected dividend per share is covered by earnings per share. It can be calculated using the following formula:
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Forward earnings per share ÷ forward dividend per share
Tesco is expected by City analysts to provide a dividend of 15.2p for the year ending February 2014. With earnings per share of 33p forecast for this year, dividend coverage of 2.2 times predicted earnings is comfortably above the safety benchmark of 2 times.
Free cash flow
Free cash flow is essentially how much cash has been generated after all costs and can often differ from reported profits. Theoretically, a company generating shedloads of cash is in a better position to reward stakeholders with plump dividends. The figure can be calculated by the following calculation:
Operating profit + depreciation & amortisation – tax – capital expenditure – working capital increase
Tesco recorded negative free cash flow of £171m last year, swinging sharply from a positive reading of £1.41bn in the previous 12 months. The result was primarily due to collapsing operating profit, which dropped 48% year-on-year to £2.19bn from £4.18bn in 2012.
A £700m cut to capital expenditure, to £3bn, failed to significantly arrest the decline, while a £375m increase in working capital also weighed on cash flow.
Financial gearing
This ratio is used to gauge the level debt a company carries. Simply put, the higher the amount, the more difficult it may be to generate lucrative dividends for shareholders. It can be calculated using the following calculation:
Short- and long-term debts + pension liabilities – cash & cash equivalents
___________________________________________________________ x 100
Shareholder funds
The supermarket giant saw its gearing ratio edge to 35.3% in 2013, from 33.1% in the previous year. Net debt actually edged lower to £6.6bn from £6.84bn, and cash and cash equivalents rose to £2.51bn from £2.31bn. However, a marked decline in shareholders’ funds was responsible for the gearing increase — these fell to £16.66bn from £17.8bn.
Buybacks and other spare cash
Here, I’m looking at the amount of cash recently spent on share buybacks, repayments of debt and other activities that suggest the company may in future have more cash to spend on dividends.
Tesco is aiming to keep investment activity bubbly as it seeks to rejuvenate its domestic businesses, push into lucrative emerging markets — particularly across Asia — and drive its multichannel expansion, led by its highly-successful online operations.
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Tesco’s falling market share at home, and declining fortunes in foreign markets — typified by its high-profile withdrawal from the US — has severely dampened investor confidence for more than a year. And the metrics discussed above could potentially worsen as the effect of sustained competition pressure the company’s accounts and its recovery strategy takes time to get off the ground.
Still, Tesco has said that it is aims to deliver dividend growth ‘broadly in line with underlying earnings‘, and I believe that the retailer has both the know-how and financial clout to deliver on its turnaround strategy over the medium-to-long term.
In the meantime, a prospective dividend yield of 4.5% for 2014 is far ahead of the 3.3% FTSE 100 average. Although Tesco bucked its multi-year trend of full-year dividend increases last year, keeping the payout on hold as earnings slipped, I expect a return to growth from this year — albeit at modest levels initially — to herald fresh opportunities for those seeking plump payouts.
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> Royston does not own shares in any company mentioned. The Motley Fool owns shares in Tesco.
