Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)
Apple (AAPL) has been all over the news as of late, and everybody has an opinion about what Apple should do with its cash load. Though we favor a value-creating acquisition within its supply chain as one potential option, hiking its dividend substantially is another. In Apple’s case, the firm’s capital structure, which we consider in the firm’s cash-flow based dividend coverage ratio (the Valuentum Dividend Cushion), is a huge plus with respect to future potential dividend growth. Not only does its net cash position support future dividend payment expansion, but its future free cash flow generation does as well. Cash-flow based analysis is far better than only using the payout ratio, which depends heavily on accounting earnings (which can at times be less informative of economic reality). Regardless of what you think Apple’s fair value may be, its dividend growth potential is fantastic. Let’s dig into why below.
Apple’s Investment Considerations
Apple’s Return on Invested Capital
Apple’s dividend yield is slightly above average, offering just at a 2.4% annual payout at recent price levels. We prefer yields above 3% and don’t include firms with yields below 2% in our dividend growth portfolio. So Apple doesn’t quite meet our criteria just yet.
However, as many investors can attest to, the safety of Apple’s dividend is excellent (please see our definitions at the bottom of this article). We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won’t cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.
That has led us to develop the forward-looking Valuentum Dividend Cushion™. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we’d like to see a score much larger than 1 for a couple of reasons: 1) the higher the ratio, the more “cushion” the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future.
For Apple, this score is an incredible 3.9, revealing that on its current path the firm can cover its future dividends with net cash on hand and future free cash flow roughly 4 times. We also use our dividend cushion as a key decision component in choosing companies for addition to the portfolio of our Dividend Growth Newsletter (please see our links on the left sidebar for more information).
Now on to the potential growth of Apple’s dividend. As we mentioned above, we think the larger the “cushion” the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management’s willingness to increase the dividend. Since Apple’s board only recently established its dividend, the firm receives no demerits on this assessment. Plus, being able to cover its existing dividend 3.9 times suggests that a doubling of the dividend within the next four years is highly plausible, if not probable (please view our forecasts in the image above).
And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Apple’s case, we currently think the shares are undervalued (click here to read: ‘Regardless of Price, Apple’s Intrinsic Value Is Still on Its Way to $1,000’), so the risk of capital loss is low. All things considered, we like the potential growth and safety of Apple’s dividend. And if we get any further movement on Apple with respect to its dividend, we won’t hesitate to add it to our Dividend Growth portfolio.
Additional disclosure: AAPL is included in our Best Ideas portfolio.