Where Next for Diageo's Dividend?

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, to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at Diageo  (LSE: DGE  )   (NYSE: DEO  ) , the owner of drinks brands such as Guinness, Johnnie Walker, and Smirnoff.

165% in 10 years
Diageo's share price has risen by 165% over the last decade, as the company has delivered relentless growth through acquisitions and organic expansion. As a result, it trades on a fairly heady price to earnings ratio of 23.5 and offers a dividend yield of just 2.4%. However, Diageo has grown its dividend at an average rate of 5.9% per year over the last five years, which, when combined with its impressive share price growth, means that anyone who bought Diageo shares five years ago, when they traded around 1,080 pence, will have enjoyed a dividend yield on cost of 4% this year -- plus a 75% capital gain to date.

Diageo's apparently divine progress was checked slightly this week when it was forced to admit failure in its efforts to take over the Cuervo tequila brand, which it currently distributes and which was seen as a natural deal for the firm. However, shareholders -- especially income investors -- should probably applaud Diageo for refusing to overpay and preserving its cash for a more fairly priced purchase. It's still possible that a deal will happen in the future, as Cuervo will have no distribution deal outside Mexico once its current deal with Diageo ends in June 2013. There is also a possibility that Diageo could set its sights on Beaminstead, which owns the world's second-biggest tequila brand and some attractive whiskey brands, too.

Well-judged acquisitions have fueled Diageo's growth, but have they left it short of free cash flow for dividends, or has the company's management found an ideal balance?

Does Diageo 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 Diageo's cash flow from the last five years:

Year

2008

2009

2010

2011

2012

Free cash flow (million pounds)

681

1,103

1,819

1,749

278

Dividend payments (million pounds)

857

870

914

973

1,036

Free cash flow/dividend*

0.8

1.3

2.0

1.8

0.3

Source: Diageo company reports. *A value of >1 means the dividend was covered by free cash flow.

Is Diageo's dividend safe?
Over the last five years, Diageo's dividend payments have been covered by free cash flow an average of 1.2 times. Like most companies, its free cash flow fluctuates from year to year, but this positive average suggests that the firm is getting the balance right and can afford both its dividend payments and its acquisitive habits.

Diageo has a strong history of dividend growth and its payout has risen every year since 1999, during which time the dividend has grown by 123% -- well above inflation and most people's salary growth. The trend looks likely to continue this year -- brokers are penciling in a forecast total dividend of 46.8 pence for 2013, which would represent a 7.6% increase on 2012.

In conclusion, I think that Diageo's dividend payout looks pretty safe and I expect it to continue to match or beat inflation over the next few years.

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 Oct. 31, 2012, during which time the FTSE All-Share index managed a gain of only 125%.

Mr. 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 pounds of private investors' funds under management -- more than any other City fund manager.

You can learn about eight of Neil Woodford's largest holdings and how he generates such fantastic returns in this exclusive Motley Fool report. It's completely free, but is available for a limited time only. I strongly suggest you click here and download the report today to avoid missing out.

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