| As you know, every Wednesday in my Safety Net column, I typically review the dividend safety of a company that's been requested by Wealthy Retirement readers. Safety Net is the most popular column in Wealthy Retirement, and we've been publishing it for nearly 12 years. Today, in the spirit of "teaching a man to fish," I'm taking you behind the scenes to show you exactly how I determine the safety of a company's dividend. As far as I can remember, I've never outlined my full Safety Net criteria before, so I'm eager to share the details with you. The first thing I look at is free cash flow. I focus on free cash flow rather than earnings because earnings include all kinds of non-cash items and are easily manipulated. For example, earnings can include revenue that has been recognized but not received. Let's say a company books a $1 million sale on December 29. Those funds would count toward the company's revenue for the year, and that revenue would then trickle down the income statement, with a portion of it being added to earnings. However, the company sends the invoice on December 30 and, as of December 31, has not been paid. That $1 million still counts toward the year-end revenue and earnings totals, but it won't be reflected in free cash flow because the company has not received the money yet. Another example is stock-based compensation. When a company grants stock to employees, it is counted as an expense that lowers earnings. But no cash went out the door, so it doesn't affect cash flow. In short, cash flow is how much cash the company actually brought in (or sent out). When it comes to evaluating the safety of a company's dividend, we want to see that the cash the company generated is enough to cover the dividend. That's because dividends are paid in cash, not in "earnings." The best way to determine whether the cash is sufficient to cover the dividend is by calculating the company's payout ratio, or the percentage of its free cash flow that it pays out in dividends. (Most people use earnings to calculate payout ratio, but I prefer free cash flow for the reasons I explained above.) We calculate free cash flow by going to a company's statement of cash flows and subtracting its capital expenditures from its cash flow from operations. Below is McDonald's' (NYSE: MCD) statement of cash flows from its 2023 annual filing with the SEC. The key numbers we're looking at are cash provided by operations, capital expenditures, and common stock dividends. You can see that cash flow from operations was $9.612 billion and capital expenditures (sometimes known as "capex") were $2.357 billion. To arrive at our free cash flow figure, we subtract capex from cash flow from operations. McDonald's' free cash flow comes out to $7.255 billion. Then we look at common stock dividends, which totaled $4.533 billion. This tells us that McDonald's paid out $4.533 billion out of the $7.255 billion that it generated in cash. That's a payout ratio of 62%. If we'd used the $8.469 billion earnings figure (shown in the "net income" row at the top of the page) to determine the payout ratio, the payout ratio would've been 54%. But remember, dividends must be paid in cash, so we're not interested in what percentage of earnings the company paid out in dividends. We need to know what percentage of its cash was paid out in dividends. | 
No comments:
Post a Comment