The Dividend Cushion Ratio: Unadjusted Is Less Subjective, Adjusted Is More Subjective
publication date: Mar 23, 2023
author/source: Brian Nelson, CFA
Image Source: Mike Lawrence
Question: I'm a subscriber.
I'm looking at your Dividend Report for Enterprise Product Partners (EPD). It says your Valuentum Adjusted Dividend Cushion ratio for EPD is 1.8 (a ratio that includes future expected proceeds from capital raising endeavors in the coming years), but several lines below it says the Unadjusted Dividend Cushion ratio, which is your regular normal ratio (a ratio that does not include future expected proceeds from capital raising endeavors in the coming years), is 0.22.
Please explain the difference between the two ratios, and what is considered a good ratio for the Unadjusted Dividend Cushion ratio, what is an excellent score, what is neutral and what is poor? Also, how much relative importance should I give to each ratio?
Also, further down in the section on Unadjusted Dividend Cushion, the chart of EPD has a large negative number in the blue bar, and your text says: "Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less durable a company's dividend." So that means that EPD's dividend isn't durable, yet your report earlier says that EPD's Dividend Safety rating is GOOD.
Can you elaborate?
By Brian Nelson, CFA
Thank you for your question.
It is a great one because it hits at the heart of the capital-market-dependency risk that has traditionally been inherent to master limited partnerships (MLPs), and a risk that is heavily present within real estate investment trusts (REITs). MLPs and REITs are much different operating structures than corporates (e.g. a general industrial stock) with far different financial make-ups, and this necessitates much greater flexibility in the interpretation of our dividend methodology for such variant business structures. These entities require both an Unadjusted Dividend Cushion ratio and an Adjusted Dividend Cushion ratio, and sometimes qualitative adjustments to their dividend ratings, too, in our view.
First, what is capital-market dependency risk?
Capital-market dependency risk occurs when a company's traditional free cash flow, as measured by cash flow from operations less all capital spending, is consistently negative or regularly far less than what a company pays out as dividends and/or distributions. These types of companies, which are often net debt heavy, operate at the whim of the health of the financial and credit markets, meaning that in the most general sense, if the capital markets are "open" and access to new capital is easy and fluid, financial and dividend health at such companies can be sustained. However, if the capital markets are restrictive or too expensive, financial and dividend health at such companies are more suspect.
In many cases, capital-market dependency risk often results in a two-poles interpretation of the firm's financial and dividend health (as illustrated by the application of the Unadjusted vs. Adjusted Dividend Cushion ratio, at times) depending on broader market and credit conditions. Quite simply, the dividend health for a capital-market dependent company can be good or bad depending not just on the company's future expected fundamental operations and cash-flow generation, but also whether the capital-market dependent entity can access new equity and new debt easily and at affordable prices, the latter a very important consideration in times of cash shortfalls and one that is largely beyond the company's control--particularly during times of tight credit.
Here is what we wrote about this dynamic with respect to the REITs recently:
Structurally speaking, REITs are more at risk of dividend cuts than corporates, which can retain significant net cash on their balance sheets as they manage their payouts such that traditional free cash flow, as measured by cash flow from operations less all capital spending, can comfortably cover the dividend. This will always be the case, regardless of whether a REIT uses triple net leases or is tied to a favorable secular growth trend. In this regard, assessing the health of a REIT's dividend is much more complicated than that of a corporate because, in many cases, it relies heavily on an assessment of external capital market conditions and the REIT's credit quality.
This is why we use both an Adjusted Dividend Cushion ratio and an Unadjusted Dividend Cushion ratio in our work--the former considers access to the capital markets in the assessment (and proceeds from future expected capital raising), while the latter does not. At the core, the Dividend Cushion ratio measures the financial capacity of a company to pay and grow its dividend. As it relates to the Unadjusted ratio, it sums up the existing net cash (total cash less total debt) a company has on hand (on its balance sheet) plus its expected future free cash flows (cash from operations less all capital expenditures) over the next five years and divides that sum by future expected cash dividends (including expected growth in them, where applicable) over the same time period. The Adjusted Dividend Cushion ratio, however, includes external capital to be raised in the numerator and is much more subjective than its Unadjusted counterpart.
As a forward-looking free-cash-flow dividend coverage metric that considers the balance sheet, the Dividend Cushion ratio is one of a kind, in our view. An elevated ratio doesn't ensure the company or REIT will keep paying dividends, however, as management's willingness to do so is another key consideration, but the ratio acts as a logical, cash-flow based ranking of dividend health, much like a corporate credit rating, for example, ranks a company's ability to pay back debt (default risk). We view the Dividend Cushion ratio as an indispensable and unmatched feature of our service and use the ratio as a key consideration with respect to companies in the Dividend Growth Newsletter portfolio and High Yield Dividend Newsletter portfolio.
With this background about capital-market dependency risk clearly outlined for REITs, in particular, and MLPs, more generally, let's talk more about the calculation of the Unadjusted Dividend Cushion ratio. As noted above, the measure adds a company's net cash position to the sum of the firm's future expected free cash flows (cash flow from operations less all capital spending) over the next five years and takes that sum and divides it by the sum of the company's future expected cash dividends paid and growth in them over the next five years.
The Dividend Cushion ratio is essentially a balance-sheet oriented, cash-flow dividend coverage ratio -- the higher the ratio above 1, the better able the company should be able to cover dividend payments in the future based on our forecasts. We think the Dividend Cushion ratio has significant improvements over other ratios such as total debt/EBITDA, which only considers one year of "earnings," as well as the dividend payout ratio (dividends paid per share divided by earnings per share), which doesn't even consider the health or lack thereof of the company's balance sheet.
Image: The calculation of the raw, undajusted Dividend Cushion ratio.
For most of our coverage universe and for most corporates, more generally, the qualitative dividend ratings in the Dividend Report for 'Dividend Safety' and 'Dividend Growth Potential' are a pure function of the Unadjusted Dividend Cushion ratio, as shown in the mathematical calculation above. The breakpoints for the Dividend Cushion ratio to determine an EXCELLENT, GOOD, POOR, and VERY POOR dividend rating are explained later in this article.
Stocks (corporates) that fit the Unadjusted Dividend Cushion ratio process above can be found in the retail, industrial, pharma, technology, and several other non-financial sectors. These companies' financial statements and business operations are rather straightforward to analyze, and their capital-market dependence risk, or need for the external capital markets to consistently remain open to them, is often negligible or absent. Think about the net-cash-rich balance sheets and strong future expected free cash flows at Apple (AAPL) or Microsoft (MSFT), for example, and how both of these tech giants don't need external capital at all.
The Importance of the Adjusted Dividend Cushion Ratio
For MLPs, REITs, and some utilities, however, we make modifications to the Unadjusted Dividend Cushion ratio in deriving the Adjusted Dividend Cushion ratio. For example, with respect to MLPs, we add back future expected equity issuance over the next five years to the numerator and mitigate the company's debt load to a degree on account of assuming ongoing refinancing capacity for such entities.
These adjustments result in a sharp upward revision to the Dividend Cushion ratio that we use in arriving at a capital-market dependent entity's qualitative dividend ratings in the Dividend Report for 'Dividend Safety' and 'Dividend Growth Potential.' Though we base the qualitative dividend ratings on this Adjusted Dividend Cushion ratio for MLPs, REITs, and some utilities, we also disclose the Unadjusted Dividend Cushion ratio in each case, which also drives the charts and graphs in the Dividend Report.
But why make things so complicated?
Well, without consistent access to new capital at affordable prices, capital-market dependent dividend-payers would have a very difficult time continuing operations, let alone keep paying their dividends during tough times. We want readers to know and understand this. But tough times are often fleeting, and during good times (or rather most of the time), a capital-market dependent entity's payout may be okay given continued access to the capital markets.
One can start to see that the analysis that assesses the financial health of a capital-market dependent entity's dividend becomes far more subjective than that of the same analysis of a corporate such as Apple or Microsoft. In many cases, it often comes down to the idea that if a capital-market dependent entity can keep raising capital (new debt and new equity), it can keep paying the dividend. If it can't, the dividend is then in jeopardy.
Though this view may be highly unsatisfying of an assessment to investors of REITs, MLPs, and some utilities that want one unwavering, decisive answer regardless of where we are in the credit cycle, for capital-market dependent entities, any decisive conclusions will almost always remain elusive as such companies' financial and dividend health are largely beyond even their own control when the going gets tough and capital markets freeze up.
Breakpoints and Other Qualitative Adjustments
The assigned breakpoints for the Dividend Cushion ratio are as follows for both measures, as it is generally up to the user of our research to determine which measure, the Adjusted or Unadjusted one, to rely upon for capital-market dependent entities. In good times, perhaps the Adjusted measure is most relevant. In bad times, perhaps the Unadjusted measure makes the most sense.
The following breakpoints can be found on the definitions page in the Dividend Report in the back:
Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion™. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
In some cases, we may make futher qualitative adjustments to the dividend ratings themselves on account of other factors. If a company's Dividend Cushion ratio may be near parity [close to 1, but still shy of it (e.g. 0.5-0.9)], we may assign a better qualitative dividend rating than what the breakpoints may indicate.
For example, at the time of this writing, March 23, 2023, there are a number of companies including Kimberly-Clark (KMB), IBM (IBM), Digital Realty Trust (DLR), Air Products & Chemicals (APD), PepsiCo (PEP), Sysco (SYY) Coca-Cola (KO), and Union Pacific (UNP) that have Dividend Cushion ratios between 0.5-0.9, but receive GOOD 'Dividend Safety' and 'Dividend Growth Potential' ratings. Several of these companies are Dividend Aristocrats with steady consumer staples business models, and we're not ready to assign them POOR dividend ratings.
Wrapping Things Up
All told, we like that the Dividend Cushion methodology is rigid enough to capture pure forward-looking financial risks to a company's dividend payout with the Unadjusted Dividend Cushion ratio, flexible enough to consider a capital-market dependent company's ability to tap the equity markets to meet the dividend payout with the Adjusted Dividend Cushion ratio, and just subjective enough to make adjustments to the qualitative ratings for borderline cases.
In conclusion, we believe both the Unadjusted Dividend Cushion ratio and the Adjusted Dividend Cushion ratio offer important insights to the reader. The former reveals the capital-market-dependency risks inherent to business models of MLPs, REITs, and some utilities, for example, while the latter acknowledges that under benign market conditions, continued funding of these capital-market entity's distributions and dividends by external means is likely to ensue.
We place greater emphasis on the Unadjusted Dividend Cushion ratio because it is more of a pure risk measure of the financial health of the dividend payment than the Adjusted measure, which considers a variety of incremental funding sources, which of course cannot be guaranteed during difficult credit conditions. Though the Unadjusted Dividend Cushion ratio is used in measuring the efficacy of the methodology, both are extremely valuable to use together to assess myriad financial risks to a company's dividend payout.
Please let us know if we can elaborate futher, and thank you for reading!
Did You Know? The Dividend Cushion ratio has done a fantastic job both in identifying strong dividend paying companies and anticipating dividend cuts, "Efficacy of the Dividend Cushion Ratio.
Energy pipeline MLPs have significantly reduced their capital-market dependency risks during the past several years. Read more here: Energy Pipelines: What a Difference A Few Years Have Made!
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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, RSP, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson's household owns shares in HON, DIS, HAS, NKE, DIA, and RSP. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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