Payout Percentages Matter – When You Use The Right Ones

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I'm always fascinated when an entire article is written based on a faulty premise. A recent article by the Motley fool's own Austin Smith, caught my attention because of his title. The title of the article was, “3 Dow Stocks That Shouldn't Pay You Any More.” I'm always interested to see which companies could be in financial turmoil, and in particular if their members of the Dow 30. However, Austin's methodology is a little flawed as he compares both dividends and stock buybacks over the last 5 years, to total earnings during the same period. In summary, he suggests that certain companies that paid out less than 100% of their total earnings, are more “prudent” with their cash management. The problem is total earnings sometimes have nothing to do with what a company can afford to pay.

While I applaud Austin's mathematics in researching total dividends, stock buybacks, and total earnings, over a five-year period for multiple companies, I wish he had used cash flow numbers instead. Many times in both Motley Fool articles as well as writings by my favorite investor of all time Peter Lynch, there are references made to net earnings not painting a true picture of the company's capabilities. Earnings after all can be manipulated, but cash flow more accurately depicts a company's real ability to return profits to their shareholders.

Prudent Stocks Versus Too Generous Companies:

The 4 companies that Austin selected as “prudent” were Cisco Systems, ExxonMobil (NYSE: XOM), Merck, and General Electric. These 4 companies had a five-year payout ratio versus total earnings of between 88% and 95%. The companies he selected as “too generous,” were Alcoa, Home Depot, Bank of America (NYSE: BAC), and Verizon (NYSE: VZ). Austin's assumption is these prudent companies showed better returns because they paid out less than 100% of their total earnings in dividends and through share repurchases. The companies that were too generous he assumes had worse performance, because they paid out over 100% of their total earnings.

One problem that I have with his selection of companies is the “too generous” basket of stocks includes Bank of America. The company's returns have very little to do with how much the company paid in dividends, or how many shares the company repurchased. In truth, one primary reason for the meltdown in Bank of America's stock, had to do with the fact that the company invested in what was the largest mortgage lender, in the middle of a housing bubble. Given the last several years have seen the most widespread drop in average house prices on record, this is a huge contributing factor towards the negative returns of this 2nd portfolio. Just to prove the point that the methodology of using net income versus cash flow is flawed, let's take a look at two of the companies that Austin selected in each of these baskets of stocks.


ExxonMobil Case Study:

One example that Austin picked was ExxonMobil. The difference between net income and cash flow is not insignificant as he suggests by saying there is, “technically a little room left for more handouts.” ExxonMobil's operating cash flow has been between $1.35 billion to $9.8 billion higher than net income over the last year. In the last 3 years, the company's operating cash flow has been higher than net income by as much as $18 billion. This is critically important to understand, as in 2011 using just net income, ExxonMobil utilized about 75% paying dividends and repurchasing shares. However, the company actually generated over $64 billion of cash, and spent nearly $31 billion on capital expenditures. This leaves $33 billion left to use towards dividends and share repurchases. The company spent $30.5 billion paying dividends and repurchasing shares, leaving just $2.5 billion. As you can see, looking at net income gives us a 75% utilization, however in real cash the company used about 96%. The point is, that income does not accurately reflect the cash available to a company, and makes no adjustment for capital expenditures.


Verizon is Anything But Too Generous:

A second example is Verizon, which Austin identified as paying out more than its net income. My primary issue with his selection is, the company's historically high depreciation allowance. In fact, in the last 3 years Verizon's depreciation allowance has been at least $16 billion each year. During this same period, the company's total earnings have been between $2.4 billion and $4.8 billion. When a company's depreciation accounts for as much as 87% of cash flow, looking at net income alone makes no sense. Not to belabor the point, but Verizon generated an average of nearly $15 billion in free cash flow in the last 3 years. Considering the fact that the company's dividend payments have been between $5.2 billion and $5.5 billion, clearly the company is not being “too generous.”


Look At Free Cash Flow Not Net Income:

As you can see, investors need to be careful using only net income when comparing dividend payments and share repurchases. This is a mistake that many investors make, and I used to make myself. Goodwill from acquisitions, and large capital investments, both cause large depreciation allowances. These depreciation allowances have to be accounted for, but are non-cash charges. If you're comparing companies to decide which one is the better investment, it makes sense to compare free cash flow. Since free cash flow is usually what pays for dividends and share repurchases, this is a more accurate description of what a company can do for its investors.

MHenage owns shares of Verizon Communications. The Motley Fool owns shares of Bank of America and ExxonMobil. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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