Dividend Report Card: Chevron

All dividends are not created equal.

We learned this lesson the hard way in recent years. In the first quarter of 2009 a record 367 firms cut their dividend payouts only to be followed by another 250 in the next quarter. Because dividends are at the board of directors' discretion, when times get tough a firm's dividend payout can meet the corporate chopping block.

Avoiding the executioner
Certainly things have gotten better since those dark days, but with many concerns remaining about the global economy, investors would be wise to ask the following three questions of their companies' dividends:

1. Over time, has this company steadily increased its payouts?
2. How sustainable is the dividend?
3. Does the company have room to further increase the dividend?

To help you out, I've created a proprietary dividend report card that seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic Eight-Ball, but it will hopefully get you pointed in the right direction.

Today's pupil is Chevron (NYSE: CVX).

Dividend history
Income-minded investors prefer a good track record of rising dividend payouts. Not only is it a sign that management is dedicated to returning shareholder value, but also that the board of directors expects future profitability.

Let's see how well Chevron has increased its dividend over the past five years, relative to its earnings growth:

Data provided by Capital IQ, as of July 19, 2010.

Generally, you'd prefer to see a closer alignment of the dividend and earnings growth rate, but given the cyclicality of the oil industry, the divergence isn't necessarily cause for alarm. Still, it's something to keep an eye on in coming years.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Chevron scores a 5 of 5.

Sustainability
Finding companies with solid financial footing, backed by a strong balance sheet, sufficient profitability, and plenty of free cash flow is at the root of successful dividend investing. There's no point buying a stock yielding 5% if you don't believe the dividend is sustainable. For this reason, sustainability gets a 50% weighting in my formula.

To analyze dividend sustainability, I look at three factors:

1. Interest coverage ratio (EBIT / interest expense).
2. Earnings dividend payout ratio (dividend per share / earnings per share).
3. Free cash flow dividend payout ratio (Dividends paid / Free cash flow to equity).

It's worth noting that in my definition of free cash flow to equity, I also back out any acquisitions the company's made over the past 12 months. Hey, that's cash that could have been paid out as a dividend! Plus, serial acquirers may cut a dividend to help fund a new acquisition, so we want to be sure there's still plenty of cash to go around after all investments have been made.

For Chevron, the results are:

Data provided by Capital IQ, as of July 19, 2010.

Chevron generates more than enough profits to repay its creditors and pay the dividend, but the free cash flow payout ratio is fairly high. Again, its part of the cyclicality of the oil business, but it's another thing to monitor.

Growth
Once you know that a dividend is sustainable, you'll want to see how much room the company has to raise its payout. It may not be quite as important as dividend sustainability, but it's still an essential factor for income-minded investors who want their payouts to increase at rates well above inflation.

For this reason, growth makes up the last 40% of the final grade.

In this section, I once again use the earnings and free cash flow payout ratios. Only this time I'm not just looking to see if there's more than enough profits and cash to sustain the dividend. I want to see how much the payout can grow, so the lower the payout ratios, the better.

I also consider a firm's implied sustainable growth rate, defined as return on equity times its retention ratio (the percentage of profits it keeps to reinvest in the business). This is the highest achievable growth rate the company can have without changing its capital structure.

Here's how Chevron scored on these metrics:

Even though its free cash flow payout ratio is high, that could correct itself over time. In the next five years, dividends may not increase at the double-digit rate they have over the previous five, but a high-single-digit rate is certainly not out of the question.

Bonus factor
An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against direct competitors'. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

Given these yields and the major integrated oil and gas sector average yield of 3.7%, Chevron's current yield of 4% doesn't appear to be out of the ordinary.

Pencils down!
With all the numbers in, here's how Chevron's dividend scored:

Chevron checks out on just about every category except on the free cash flow measures. Cash flow gets a higher weighting on this list because I want to see that the payouts are backed by actual cash and not accrual-based earnings.

With a "B-" it doesn't appear the dividend is in any imminent danger, but investors should keep an eye on Chevron's ability to generate free cash flow in the coming years. If it can, it could easily score a "B+" or better.