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, since 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'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 (UKX), to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at global megaminer BHP Billiton .
Understanding big miners
Global miners such as BHP, Rio Tinto, Xstrata, and Anglo American have become volatile economic barometers, and their share prices often rise and fall dramatically on a daily basis, as market sentiment changes. As I write, for instance, BHP Billiton's shares are up by 4.1% on this morning's opening price, thanks to yesterday's fiscal cliff tax deal in the U.S. -- even though the deal postpones the most important decisions, those relating to spending cuts.
For long-term investors, this volatility can be distracting, and it's important to ignore this short-term noise. Miners like BHP are lumbering giants with global assets that often require billions of dollars of capital investment to bring into production, and may have lifespans of several decades. Although these big miners often have high profit margins, the risk they take is in forecasting future demand for the output of their mines -- commodity prices tend to plunge when demand weakens, and when that happens, mining firms' share prices usually fall too, as they have little choice but to tighten their belts and wait for demand to recover.
From a dividend perspective, the appeal of owning shares in a global mining company is that it provides an income derived directly from major commodities, such as iron ore, copper and aluminum. Although the intensive capital investment required to develop new assets means that miners do not commonly pay high dividends, this situation may improve over the next few years, as companies like BHP scale back their expansion plans in the face of weaker commodity prices, and focus on making the most of their existing assets. Potentially, this could free up more cash with which to pay dividends.
Does BHP Billiton 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 BHP Billiton's cash flow from the last five years:
Free cash flow ($m)
Dividend payments ($m)
Free cash flow/dividend*
Source: BHP Billiton company reports. *A value of >1 means the dividend was covered by free cash flow.
The majority of BHP's dividends over the last five years have been covered by free cash flow. The exception to this was in 2012, when BHP's capital expenditure rose from $16 billion to $32 billion, despite a fall in profits. Much of this expenditure was pre-committed and it is worth noting that BHP also announced cuts to planned future spending worth $30 billion last year, as it sought to bolster its profit margins against falling commodity prices.
Is BHP Billiton's dividend safe?
On average, BHP Billiton's dividend payments have been covered by free cash flow 1.4 times over the last five years. That gives me a reasonable degree of confidence that this miner's dividends are affordable and will usually be paid out of free cash flow.
Looking forwards, I think that BHP Billiton's dividend looks pretty safe and that the company is likely to maintain its recent record of annual dividend increases, albeit at a slower rate.
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 fifteen years to October 2012, during which time the FTSE All-Share index managed a gain of only 125%.
Woodford selects stocks that he believes are undervalued and likely to deliver strong dividend growth. His record is one of the best in the City and at the end of October 2012, he had £21 billion of private investors' funds under management -- more than any other City fund manager.
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The article Where Next for BHP Billiton's Dividend? originally appeared on Fool.com.
Roland Head owns shares in Rio Tinto but does not own shares in any of the other companies mentioned in this article. The Motley Fool has no positions in the stocks mentioned above. 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.
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