LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, because dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.
A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.
In this series, I take a look at the cash flow statements of some of the biggest names in the FTSE 100 to see whether their dividends are being funded in a sustainable way -- from genuine spare cash. Today, I'm looking at Anglo-Dutch consumer goods giant Unilever .
A strong year
Unilever's share price has soared in 2012, and at the time of writing it's trading within a whisker of its all-time high. For a long time, the company had a reputation as a low-growth, steady business, but in recent years a determined focus on emerging-market growth has delivered impressive rewards for shareholders, as have its defensive properties and skilled management. People don't stop buying soap, washing powder, or margarine in a recession -- and bread-and-butter products like these, coupled with well-known brands, form the core of Unilever's business.
Since the stock market touched bottom in 2009, Unilever has consistently outperformed the FTSE 100 and its dividends have grown strongly too -- so how affordable are Unilever's dividends, and can their growth be maintained?
Does Unilever have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments, and tax deductions. With that in mind, let's look at Unilever's cash flow from the last five years:
Free Cash Flow (millions of euros)
Dividend Payments (millions of euros)
Free Cash Flow/Dividend*
Source: Unilever annual reports. *A value of more than 1 means the dividend was covered by free cash flow.
A brief look at the table above shows that Unilever's dividends are typically quite generously covered by free cash flow. On average, free cash flow is 1.5 times the dividend payout, which is quite attractive. A couple of exceptions stand out: In 2008, free cash flow was unusually high because Unilever sold some of its assets, while in 2011, the opposite happened, and Unilever spent $3.7 billion on acquiring the Alberto Culver Company. This acquisition included hair care brands such as TRESemme and Alberto VO5, which made Unilever the world's second-largest shampoo business but did wipe out its cash flow for the year.
This kind of short-term fluctuation is quite normal for a big business, and Unilever's first-half results for 2012 show a return to business as usual: It generated more than 1 billion euros of free cash flow in the first six months of the year.
Is Unilever's dividend safe?
Unilever's products are mostly household staples and are the kind of thing we don't stop buying, even when money is tight. The prices of consumer goods like these also tend to keep pace with inflation, which should help to protect Unilever's profit margins over the long term.
In addition to these attractive defensive qualities, Unilever's emerging-market growth has transformed it from a business whose revenue didn't change for several consecutive years to a 31 billion pound blue chip with genuine growth prospects. As a shareholder myself, I love the combination of qualities that Unilever brings to the table -- but will my quarterly dividend payments keep on ticking up each year?
My brief look at Unilever's free cash flow has shown me that the company has a respectable ability to generate free cash and periodically uses this to add new products to its stable of brands. Unilever chief executive Paul Polman has been in the job longer than most of his FTSE 100 peers, and his management appears to have placed the company on a sustainable and successful path.
I'm confident that Unilever's dividends are some of the safest in the FTSE 100, and I fully expect to see them continue to rise over the next two years, probably slightly ahead of inflation.
Top income tips
One man who really understands how to assess the quality of a company's dividends is legendary City fund manager Neil Woodford, whose High Income fund grew by 342% over the 15 years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only, so I strongly suggest you click here and download the report today to avoid missing out.
The article Where Next for Unilever's Dividend? originally appeared on Fool.com.
Roland owns shares in Unilever. Motley Fool newsletter services recommend Unilever. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.