A couple of caveats to start out with

I’m going to be talking about US stocks in this post.  Company attitudes toward dividends–and toward caring for shareholders in general, for that matter–vary from country to country.  So, too, do investor preferences for dividends.  Tax regimes are also important.  If a dividend recipient has to pay income tax at an 80%-90% rate on the distribution (as was the case in Japan in the Eighties), paying a dividend is an exercise in futility.

Before buying any stock, except if you’re hoping for a quick change of control, you’ve got to make sure that the company is viable and has decent management.  I’m assuming here that work is already done.

I’m not going to write here about highly specialized companies, like public utilities or REITS, where government regulations play a key role in what the company is able to do.

How a company determines its dividend

The dividend is recommended by management and approved by the board of directors.

In my experience, the dividend level is always set by looking a the firm’s past results, not its projections for the future.

Perhaps the most crucial consideration is whether the firm can maintain (not cut) the dividend, even in adverse economic circumstances.

Dividends are supposed to be paid out of profits. Because of this dividends are usually talked about in terms of the % of income that is paid out.  I’ve found, however, that it’s more useful to look at dividends as a % of cash flow from operations (basically net income + depreciation/amortization + deferred taxes) as a way of predicting their future course.

A two-pronged approach:  qualitative and quantitative

1.  qualitative. Like the products or services they sell, companies too have a life cycle.  When they’re young and expanding quickly to stake out territory for themselves, they typically need as much capital s they can get their hands on.  They shouldn’t–and don’t–pay dividends.  As the company matures, growth typically slows, the need for capital to fund expansion diminishes and the company begins to generate excess cash from operations.  In many cases, companies don’t recognize this shift at first.  It’s only when new investments show up with sub-par or negative returns that they start to work the new realities out.  In some cases, firms pigheadedly continue to expand, kind of like the professional athlete who wants to play “one more year,” unable to recognize that age has diminished his skills.

Ideally, you would want to find a company that is maturing, understands this and has adjusted its mindset.  It strikes me that WMT is a good example of this type of firm.  MSFT and INTC may be others.

2.  quantitative. All of the numbers I’ll be writing about can be found in a company’s annual report or 10-K.  Discount brokers may have either analyst reports or databases for customers’ use where they also can be found.  The Value Line Investment Survey, which is available in almost any library, is also a good source, because all of the historical data you’ll probably need are on a single page, with most of the ratios already calculated.

I’m going to be using WMT as an example.  I’m taking all but one of the following figures from Value Line. Here goes:

a.  dividend yield.  2.3% for WMT, slightly higher than that for the typical dividend-paying stock.

b.  dividends as % of profits.  WMT’s payout has grown from 17% of profits in 2000 to 28% in 2008.  There’s still plenty of room for it to grow safely.  The rising percentage implies, of course, that WMT has been raising its dividend at a much faster rate than profits.

c.  dividends as % of cash flow.  The growth here is from 11% to 18%.  Again, plenty of cushion to maintain the payout, as well as to grow it.  My experience is that a mature firm can easily pay out a third of its cash flow in dividends.

d.   has the dividend ever been cut?  In WMT’s case, no.  The recent times of greatest concern would be 1997, 2000-2002 and 2007-2009.  A company that reduced or eliminated its dividend during times of economic stress is, I think, more likely to do so again.

e.  when does the board usually raise the dividend?  In WMT’s case, the company has a pattern of raising the dividend with the June quarter payout.

f.  general indicators of company health.

Although WMT’s capital spending is about 2x its depreciation (i.e., it is expanding), the absolute amount of capital expenditure has been falling (source:  WMT annual reports).

Debt, at 1/3 of total capital, is reasonable and appears to be stabilizing at this level.

Returns on capital are high.

Interest expense is covered by income from operations ten times (an impressively big number).