Once we’ve employed a share screener to create a shortlist of potential high-yield portfolio candidates, we can begin to research each company more deeply.
We need to look behind the numbers thrown up by the rough-and-ready share screen to determine which companies might be worth investing in for income, and which are not.
We’ll tackle valuation in another article. Today we’ll focus on financial statement analysis specific to high-yield shares, which we’ve previously determined to be those shares yielding at least 1.2x the FTSE All-Share average.
Remember: There’s usually good reason a share is trading with a high-yield. The share price and yield have an inverse relationship, so a high-yield share often has a depressed share price.
The stock market doesn’t always efficiently price shares, but it’s usually not far off, especially with larger companies that attract more investor interest. As such, when researching high-yield shares, our top job is to identify and fully understand why the share is in fact high-yield.
Sometimes the reasons for a high dividend yield are benign, but other times there are good reasons to stay away.
When we invest in a high-yield share, we’re typically looking to generate above-average income from the investment.
As such, we first want to make sure that the dividend is sustainable. Can the company continue to pay at least this amount to shareholders going forward?
Traditional dividend cover metrics are earnings-based, but I prefer to measure dividend cover using free cash flow. The reason is that earnings are not cash, and since dividends are cash flows, it makes more sense to measure them against net cash flows to the company after it has reinvested in the business.
So how do we measure free cash flow? There are various ways to go about it, but the simplest definition (and therefore the best place to start) is to take cash flow from operating activities and subtract purchase of property, plant, and equipment (sometimes called ‘capital expenditures’ or ‘capex’).
To illustrate, we’ll look at the magazine and bookseller WH Smith. The snapshot below is from page 41 of the company’s 2011 annual report:
Fortunately for us, we can also find the gross dividend paid on the cash flow statement, making free cash flow cover fairly easy to calculate.
Taking numbers from the statement above:
|Net cash inflow from operating activities||£118m||£104m|
|Less: Purchase of property, plant and equipment||£36m||£24m|
|= Free cash flow||£82m||£80m|
|Divided by: Dividends paid||£29m||£26m|
|= Free cash flow dividend cover||2.82x||3.08x|
This is very good cover. What it’s saying is that for each £1 paid out as dividends, the company generated £2.82 and £3.08, respectively, in free cash flow in fiscal years 2011 and 2010.
Note: Firms with free cash flow cover closer to one times should be approached with caution from a dividend sustainability standpoint.
We can also see from the cash flow statement that WH Smith has used most of its leftover free cash flow on share repurchases (that’s ‘Purchase of own shares for cancellation’ on the statement). This is reassuring – if the company has a tough year or two, it might be able to slow down its repurchasing activity whilst maintaining the dividend.
WH Smith dividend payout looks solid from a cash flow perspective, in my opinion. What’s likely keeping the yield high is not its present circumstances, but rather the company’s (arguably) limited potential for growth given the increasing digital competition for traditional books and magazines, as well as wider concerns about spending on the High Street.
Get a longer perspective: Income investors should look at free cash flow cover trends over a number of years – at least seven, if possible – to notice any trends and to monitor interim results.
Balance sheet health
Companies with too much debt often end up putting the interests of their creditors ahead of the shareholders.
One way you can tell this might be the case with a company you’re considering is if its management heralds creditor-focused metrics such as EBITDA (earnings before interest taxes depreciation and amortisation) in its periodic statements, and doesn’t spend much time speaking about shareholder-focused metrics such as net income.
There is such a thing as a healthy amount of debt. All else being equal, companies with stable businesses and strong cash flows should have more debt than highly cyclical businesses, as it can lower the company’s cost of capital (due to the tax deductibility of interest expense) and enhances company value.
Bearing this in mind, we want to compare a company’s debt ratios such as net gearing ((debt-cash)/equity) against its peers and not necessarily on an absolute basis.
If the company has a good amount of debt, it also likely has a credit rating from one of the major agencies that we can consider. However we don’t want to completely rely on someone else’s opinion here. We want to do our own work, too.
We’ll use Imperial Tobacco’s statement as of 30 September to calculate net gearing:
To calculate net gearing, we add current and non-current borrowings (£1,234 + £8,333) and subtract cash and cash equivalents (£631) to arrive at net debt (£8,936). We then divide net debt by net assets (£8,936 / £6,084) to get a net gearing ratio of 147%.
Now that we have that information, let’s see how Imperial Tobacco stacks up against its global peers:
|Company||Net Gearing||S&P Credit Rating|
|Philip Morris International||N/A||A (stable)|
|British American Tobacco||128%||A- (stable)|
|Reynolds American||45%||BBB- (stable)|
|Imperial Tobacco||147%||BBB (stable)|
As you can see, there’s some variance in net gearing across the global tobacco industry, but Imperial Tobacco is not an outlier.
Other factors may also be influencing the S&P credit ratings including litigation risk, pension deficits, different leverage ratios, and the outlook for each company’s tobacco volumes.
A high-yield share may check out on free cash flow and balance sheet metrics, but we’re also interested in management’s track record of allocating capital and its attitude toward dividends.
To start, we want to see how effectively management has allocated capital between acquisitions, share repurchases, and dividends. At the very least, we want to be able to answer the following questions:
- What’s the company’s dividend track record? Does it have a stated dividend policy?
- How many acquisitions has the company made in the past five years? How large were they? Has the company been forced to take impairment charges subsequent to those acquisitions?
- Has the company repurchased shares at opportune times, or does it simply repurchase shares when it is flush with cash?
Ideally, we want to find companies that have at least a five-year track record of paying dividends and those with a stated dividend policy tied to either earnings per share or free cash flow. The reason for this is we want to be sure that dividends are ingrained in the corporate culture and important to the shareholder base.
Because high-yield shares also tend to have slower growth rates, they can be keen on making acquisitions to boost growth. As such, we want to identify companies that have made logical acquisitions – that is, acquisitions that complement its existing business – and paid good prices for them. If the company has a history of impairment charges, for instance, it may be a sign that it isn’t a good acquirer.
Finally, if a company does engage in share repurchases, we want to see that it has repurchased shares for the right reasons (i.e. the share is undervalued) and not simply because they have extra cash lying around.
Take a look at a company’s annual reports, which tell you how many shares it repurchased and how much it paid for those shares. If they have consistently paid too much, it could be a sign of poor capital allocation skills. Too many value-destructive acquisitions and the dividend could eventually come under pressure.
Do your best
Analysing free cash flow cover, balance sheet health, and management’s capital allocation skill helps us to determine dividend sustainability, which is the key to a strong high-yield dividend share.
We remain, of course, susceptible to luck despite best research efforts. Unexpected things can befall any investment thesis – both good and bad – so it’s important to remain diversified and pay attention to valuation, which we’ll discuss in a future article.
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