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 National Grid (LSE: NG) (NYSE: NGG.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
National Grid is expected to produce a dividend of 42.5p per share in the 12 months ending March 2014, according to City brokers. Earnings per share are forecast at 53.3p, meanwhile, representing dividend cover of just 1.3 times. This is well below the security benchmark of 2 times prospective earnings.
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
National Grid reported free cash flow of £381m in the year ending March 2013, down considerably from £1.02bn in 2012. Operating profit increased during the period, to £3.75bn from £3.54bn. But larger capex costs, to £3.7bn from £3.41bn, caused cash flow to deteriorate. As well, a working capital increase of £410m versus a decrease of £146m in 2012 weighed on the figure.
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 electricity play saw its gearing ratio rise to 304.2% last year from 279% in 2012. Debt advanced to £28.07bn from £23bn in 2012, while pension liabilities jumped to £3.7bn from £3.1bn. Cash and cash equivalents rose to £648m from £299m, however. A rise in shareholders’ equity, to £10.23bn from £9.24bn, also helped to mitigate the increase.
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.
National Grid has said that it expects to spend between £3.6bn and £3.9bn in the current year in capital expenditure. The firm said it this reflects “increased investment in US regulated operations and reduced replacement expenditure in the UK Gas Distribution business.”
An electrifying dividend selection
National Grid has a long-standing reputation as a lucrative dividend stock, and the business currently carries a meaty dividend yield of 5.6% for 2014 versus a forward average of 3.3% for the entire FTSE 100.
A rights issue caused National Grid’s full-year payout to fall in 2011, although this was a blip in the firm’s otherwise decent dividend history. And the yield was still comfortably above the large-cap average for this period despite the fall.
Although dividend cover falls short of the acid test of 2 times prospective earnings, I believe that the firm’s operations in a classic defensive sector helps to offset the effect of potential earnings worries. And with massive investment across the UK and North America set to continue well into the future, I reckon National Grid is set fair to record reliable earnings and thus dividend growth over the long term.
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> Royston does not own shares in National Grid.
