Earlier in January Ford doubled its quarterly dividend from 5 cents a share to 10 cents. The announcement was met mostly with joy by those already invested; however, the positive reaction wasn't shared by everyone. Some questioned whether it was a desperate act to keep the share price at its 52-week high, whether it was a bad use of cash by management, and whether the increased dividend was even sustainable. There are a lot of reports out there that repeat the same information, but none I read answered the two questions I had. Firstly, is this the best move for Ford right now? Secondly, and maybe more importantly, is this doubled dividend sustainable in the long term? Let's dig in and understand the size of Ford's dividend and what investors' should expect.
A Foolish colleague of mine, Sean Williams, says it perfectly, and humorously:
Dividend stocks are everywhere, but many just downright stink. In some cases, the business model is in serious jeopardy, or the dividend itself isn't sustainable. In others, the dividend is so low, it's not even worth the paper your dividend check is printed on. A solid dividend strikes the right balance of growth, value, and sustainability.
That last sentence is exactly what we'll be looking into. Where does Ford's new dividend strike in those areas?
To understand if 10 cents is sustainable for Ford, let's compare it to other dividends in the industry. Looking at yields (the annual dividend divided by stock price) as of Jan. 17 reveals that Ford's yield was 2.8%. That is slightly higher than Honda at 2.48% and Toyota at 1.4%. Next, let's look at the dividend payout ratio (the dividend divided by earnings per share) either from quarterly or annual information. For the calendar year 2012, S&P estimates Ford's annual EPS to come in at $1.36. Now, if you compare that number to what will be the annual dividend going forward, or 40 cents, it's a payout ratio of 29.4%. That's not a perfect comparison, because the dividend increase reflects management's optimism that EPS will grow next year, which would bring that payout ratio percentage down.
The important question now is: What the heck does 29% mean? First, let's again compare to result to Honda's since it had the next highest yield. According to Honda, it estimates the fiscal year 2013 annual dividend to be $0.76. Comparing that to S&P's FY 2013 EPS estimates of $2.75, you have a payout ratio of 27.6%.
Both ratios are similar, and hearing the amount of noise about Ford's move being too much too soon, or that is was made out of desperation, makes me think people haven't done their homework. If anything, I'd think Honda's dividend after the earthquake, tsunami, and territorial backlash in China may be more of a risk.
To get a better perspective of what a 29.4% payout ratio means, let's see what income investors look at. Most consider a payout ratio between 25%-50% a sweet spot, and anything over 50% requires the due diligence of research to better understand the situation. Typically, growing companies keep more profits and cash for organic growth and/or new product development. Those companies will have ratios around 25%. While I don't consider Ford a growth company, they do need a lot of cash to keep gaining ground in China and salvaging Europe while still having cash to refresh vehicle lineups. Ford seems to have struck perfectly around the 25%-30% payout mark, suggesting this is a sustainable amount. Just because it's sustainable, though, does that mean it was the right move?
Why not pay down debt?
Companies with higher yields and payout ratios are in mature industries where growth is limited and dividends are the best use of profits. This is where it gets tricky for Ford. Would the cash be better off used paying down more debt? Let's take a look at long term debt to capitalization.
Ford's done enough work paying down its long-term debt that I feel comfortable with it doubling the dividend. That said, I want to make sure the amount of free cash flow created is enough to keep paying debt down. More specifically, I want to see the loan to debt percentage down to 30%-35% in the next 18 months, which is a very attainable goal.
What I find perfect about the nearly 3% yield is its opportunity to offer value to a different type of investor. "The implied 3% yield now opens the stock up to an entirely new investor class," Jefferies & Co. equity analyst Peter Nesvold said. He also notes that income managers typically "look for a 4% to 5% yield typically before initiating a new position," but "might accept a 3% yield if they believe there is sufficient share price appreciation. We think Ford now meets these criteria."
Naturally, those already invested were elated for a few different reasons. One, obviously, is that their quarterly check from Ford just doubled. Secondly, this announcement showed confidence by management in fourth-quarter earnings and in its outlook for 2013, increasing the bullish trend of the stock that much more. Thirdly, it pushed the yield to nearly 3%, which opens up doors for income investors, boosting the stocks demand.
After digging in to answer my questions, I believe that Ford's doubled dividend is not only sustainable, but strikes a perfect balance in value by attracting more investors and providing profits to those already invested. I believe the increased dividend will not hamper Ford's international expansion or debt reduction. Yet again, Ford's management got it right, only furthering investors' confidence in the company for the years to come.
Ford has been performing incredibly well as a company over the past few years -- it's making good vehicles, is consistently profitable, recently raised its dividend, and has done a remarkable job paying down its debt. The stock has recently taken off, and it appears investors have started to notice what Ford is doing right. Does this create an incredible buying opportunity, or are there hidden risks with the stock that investors need to know about? To answer that, one of our top equity analysts has compiled a premium research report with in-depth analysis on whether Ford is a buy right now, and why. Simply click here to get instant access to this premium report.
The article Why Ford's Dividend Increase Is Sustainable and Perfect originally appeared on Fool.com.
Fool contributor Daniel Miller owns shares of Ford. Follow him on Twitter @StreetSmartFool. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford. 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.