Income seeking investors love Dividend Aristocrats -- companies that have increased their dividends for more than 25 years. One such candidate is diversified industrial Dover Corp. (DOV 0.26%). The question is, is it going to maintain its Dividend Aristocrat status in the future? Moreover, is now the time to buy the stock?
Return on equity
The key to a company being able to grow its dividend is a combination of its ability to generate return on equity, or ROE. Simply put, it's a measure of how much net income a company can grow from shareholder equity -- if a company can grow its income, then it can grow its dividend. However, as every Fool knows, the economy tends to go through cycles that will inevitably affect a company's ROE from year to year.
Here's a look at the 10-year ROE for Dover:
Source: Morningstar, author's analysis.
It's clear that Dover has a good long-term track record of generating ROE, with an average of 15.8% in the last 10 years. Furthermore, if you subscribe to the Dividend Discount Model, a basic valuation method, then the company is set to deliver good future returns to shareholders.
In a nutshell, the model has it that the expected growth rate of its dividend, g, is determined by the amount of earnings it retains and its ROE. Moreover, under the assumptions of the model, investors can calculate a target price for the stock, P, when they have decided upon the rate of return, r, that they require for their investment in the stock. You can follow the numbers in the following example. The share price of Dover is around $77 at the time of this writing.
| Company | D | EPS | ROE | g = ROE*(1-D/E) | r | P = D/(r-g) |
|---|---|---|---|---|---|---|
| Dover | $1.45 | $5.78 | 15.81% | 11.84% | 13.7% | $78 |
Source: Morningstar data, author's analysis.
Essentially, the table is suggesting that investors can expect a return of 13.7% a year at the current stock price if Dover can maintain its ROE of 15% and grow earnings each year by approximately 12%..
Free cash flow matters
Earnings are important, but in reality, dividends are paid out of free cash flow. The latter is simply what the company has actually generated in cash after working capital requirements and capital expenditures have been accounted for. Here, again, there is good news for Dover investors.
The following chart demonstrates that Dover consistently generates more free cash flow than EPS, with the 10-year average conversion rate of EPS into free cash flow being 119%. Moreover, note that, even in the midst of the recession in 2009, when earnings collapsed, Dover still managed to easily cover its dividend with its free cash flow.
Source: Morningstar, author's analysis.
Furthermore, the dividend in 2013 of $1.45 per share would have been covered 2.5 times by the free cash flow generated in 2009, the year in which the recession hit. All told, based on historical evidence, Dover has ample opportunity to increase its dividend in the future. Indeed, its dividend has increased at a compound annual growth rate, or CAGR, of nearly 10% per year in the last 10 years.
Qualitative analysis
While the quantitative analysis above is fine, Fools will also want to look at the company qualitatively. With the spinoff of its former communication technologies unit into a separate company called Knowles Corporation (KN 2.23%), Dover's future is even more dependent on oil and gas services spending and general industrial spending. For example, its energy and engineered systems segments contributed 34% and 29.6%, respectively, of total segmental revenue in 2013 -- adjusted for the spinoff of Knowles.
Going forward, management's plan is to generate growth via opening up new international markets and industry verticals.
The bottom line
Dover Corp's current 2% dividend yield is nothing to write home about, but the company has ample opportunity to increase it going forward. Moreover, given its history of converting income into free cash flow, and then returning cash to shareholders via dividend increases and share buybacks, Dover Corp gets a thumbs-up as a shareholder-friendly company.
It's a well-run company, and management is focusing the business on its core strengths. If you're looking for a Dividend Aristocrat with some exposure to long-term energy spending, Dover could fit the bill nicely.
