Some of my worst investments were made back in 2014/15.
That’s the year I really got stuck into investing.
I blindly piled into stocks I would never buy at such valuations today.
I look at them in my portfolio today and cringe.
Glaxo Smith Kline, Whitbread… It just hurts.
Now, while Whitbread may be a decent buy at these prices, I’m down 15% and to be completely honest, I wouldn’t be buying at these prices regardless.
Luckily, one core calculation and one change to my investment style has stopped me from getting stung further.
In this weeks article, I’m going to share that calculation with you and that change with you.
Earnings Per Share
Now, many of you would have already heard about EPS (Earnings Per Share). That’s simply a company’s net profit divided by the number of shares outstanding.
This is a key measure often touted by company management, brokers, and analysts.
Naturally, when I first got into investing this was also the key metric I focused in on – after all, that’s what the pros and other dividend bloggers were doing.
Little did I know at this point that this focus would lead disastrous investments.
Now, there’s nothing wrong with focusing in on a company’s earnings per share but it’s the use of EPS in order to determine a dividend’s safety that gets me.
Ever heard of dividend cover?
My focus on dividend cover actually lead to me investing into companies with pressed dividends!
Dividend Cover
Dividend Cover = Dividend Per Share/Earnings Per Share
For example, Company X has earnings of £1.00 per share and pays a £0.50p dividend then the above calculation results in a dividend cover of two.
1/0.5 = 2
Now, on the face of it, this makes the dividend look well covered.
After all, earnings per share could theoretically half and the dividend could still be paid.
One would assume that the dividend safe right?
Wrong, and I’m going to tell you why.
The calculation for Earnings Per Share is: Total earnings/Outstanding Shares.
So far so good.
Let’s assume Company X has earnings of £100 and 100 shares outstanding (let’s keep things simple).
100/100 = £1 Earnings Per Share.
But, what earnings per share doesn’t take into account is Capital Expenditure – the money a business spends in order to maintain, upgrade and purchase new physical assets.
If Company X spends £40 on maintenance and a further £30 on purchasing a new asset the dividend is suddenly left uncovered by cash generated through by the company’s operation.
We said above that the company paid a 50p dividend per share.
0.50 x 100 (the number of shares) = £50 total dividend paid.
Add on the £70 spend in Capital Expenditure and we can see that the company actually forked out £120 while it only generated £100 in earnings.
Where did that extra £20 come from I hear you ask?
Debt, new share issues or asset sales, all of which are reflected in a company’s cash flow statement and can be damaging over the long term.
Debt and share issues are reflected under the financing tab of a company’s cashflow statement with asset sales under other investing and cashflow items.
So should you worry if a company has to rely on asset sales, debt or share issues to pay a dividend?
Not necessarily but it means you need to dig deeper into a company’s annual report in order to find out exactly what’s going on in order to determine if adding more debt is sustainable and whether asset sales damage the overall business.
As for share issues – this is almost always bad news for investors!
Let’s take a real-world example to see how this all works out
Here’s Whitbread’s Cashflow statement.
We’ll start in 2013.
I always begin by working out a company’s Free cash flow excluding other investing and cashflow items.
This is because I want to see whether a company generates enough cash from its core operations to fund growth and pay the dividend, without the need for any cash generation from Property Plant and Equipment activity such as asset sales.
That’s Total Cash From Operations – Capital Expenditures (Capex).
2013 = £63m
Great, that’s £63m worth of SURPLUS cash that Whitbread has after all costs including Capex.
BUT, we can see that they paid out a £78m dividend meaning that they had to generate £15m.
As it happens, in 2013 WTB gained £50m from an asset sale meaning the dividend is covered (reflected in 2013’s cashflow statement)
Using this formula, we can truly work out whether a dividend is covered.
Do the maths for 2015 and you’ll see that the dividend is grossly un-covered thanks to huge Capex.
Jumping forward to 2017 we can see that the dividend has become even more pressured.
Free cash flow = 626 – 610 = £16m
WOW! The dividend paid in 2017 was a whopping £167m.
Where did the additional £151m come from!?!
Well, if we consider the other investing activities you’ll notice that Whitbread made £200m.
Fair enough right? That covers the dividend.
Well, if we dig into the annual report, we can see that much of this money (186.2m) came from the sale and leaseback of hotels & restaurants.
Thus we have uncovered a red flag!
By leasing back a hotel the company has added an overhead for a one-off payment.
This seems concerning as this sale was required due to the weight of the dividend and the huge levels of CapEx needed in the hotel and restaurant sector.
It’s also worth looking at the company’s liabilities in light of its capital-intensive nature.
2017 2016 2015 2014 2013
As we can see, total liabilities have rocketed from £1,640m in 2013 to £2,161m in 2017 with total debt nearly doubling.
This isn’t actually that bad considering how cheap debt is at present and considering that the company has also grown its assets substantially.
2017 2016 2015 2014 2013
We can see that the liability to asset ratio has remained broadly stable (Liabilities/assets)
2013 = 1640/3175 x 100 = 52%
2017 = 2161/4689 x 100 = 46%
But.
Here’s the piece of the balance sheet that makes me cry as an investor.
2017 2016 2015 2014 2013
Whitbread has issued a further 4m shares since 2013, diluting shareholder equity.
Each time a company issues shares, your stake in the company is decreased.
Someone who owns 1/100 shares in a company owns 1%.
If the company issues another 10 shares, you now own just 0.9%
Whilst 4m shares over 5 years is far from terrible, just 2.2% of total shares outstanding, when we compare this to a company with low Capex and plenty of cash to spare the importance of free cash becomes pronounced.
Here are the number of Next Plc shares outstanding;
2017 2016 2015 2014 2013
So, how do I REALLY know if a stock’s dividend is under pressure?
Simple.
These are the EXACT steps you need to do.
- Get the company’s cash flow statement.
- Do the following equation: Total cash from operations – Capital expenditure.
- Minus the dividend from this figure.
- If the remaining figure is larger than the dividend paid then you can consider the dividend safe.
WORD OF WARNING: Sometimes, stocks pay special dividends if they have surplus cash and don’t want to buyback its own shares or invest it. Because these dividends aren’t regularly paid, it’s unwise to include them whilst considering the sustainability if a stock’s ordinary dividend. As such, remember to check if the stock paid a special dividend. If the stock paid a special dividend following the following steps apply.
- Get the company’s cash flow statement.
- Do the following equation: Total cash from operations – Capital expenditure.
- Minus the dividend from this figure.
- Plus the amount paid out as a special dividend.
- If the remaining figure is larger than the dividend paid then you can consider the dividend safe.
Conversely, if there is a need for investing activities in order to cover the dividend payment, you should take a closer look at exactly what’s going on in the company’s Annual Results.
Thanks for reading and I really hope this article has been a help.
If only someone had written this and linked me to it 3-4years ago I’m sure my investments would be in a much better spot.
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As always any questions, drop a comment below or E-mail: lewys@frugalstudent.co.uk
