How to Evaluate Dividend Payers

We've said a lot about dividends here at The Motley Fool, but despite all our advice, it can still be difficult to pick the right dividend payers for your portfolio. Utility companies can be a crucial part of a dividend portfolio. Let's see which factors matter most in selecting a long-term winner from this sector.

Utility players
High-yielding utility companies Southern Company (NYSE: SO), Progress Energy (NYSE: PGN), Nstar (NYSE: NST), Exelon (NYSE: EXC), and National Grid (NYSE: NGG) can help us learn how to evaluate dividend payers. The table below displays the year-to-date, dividend-adjusted returns, as well as the current dividend yield for these stocks:

Source: Morningstar and Yahoo! Finance.

Financial aspects
There's a lot to mull over when assessing a firm's ability to preserve and grow its dividends. You can start by looking at debt and revenue. Debt can potentially inhibit a firm's ability to return cash to investors, which means you should ideally prefer companies with low debt-to-equity ratios. Revenue growth could signal increased payouts in the future, while declining revenue could warn that dividends will soon get slashed. The table below sheds insight into how these stocks compare to each other in these areas.

Source: Morningstar.

With the exception of National Grid, these utilities have very similar debt-to-equity ratios. Although National Grid has high debt, it has also experienced the most revenue growth. However, of the five stocks being evaluated, conservative dividend investors should be drawn most strongly to the modest revenue growth of Exelon and Southern Company, which both have low levels of debt. This combination is probably more stable, and will likely provide the more consistent financial performance dividend investors seek.

Cash considerations
Obviously, you can't pay dividends without cash. Unfortunately, a company's cash position is much less clear-cut. Free cash flow growth is a key indicator that helps you more closely evaluate a company's ability to fund its dividend.

These companies have experienced very different rates of free cash flow growth over the last three years. All of them are profitable, but Southern Company and Progress Energy have watched their free cash flow get clobbered into negative territory. You can blame capital expenditures resulting from new construction of power plants, as well as new regulatory requirements. Should those burdensome costs continue in the future, it may be difficult for these companies to maintain their dividend payments.

In contrast, Exelon, Nstar, and National Grid have increased their free cash flow, somewhat significantly for the latter two. That's a vital consideration for dividend investors. Nstar has stated that capital expenditures will change little in the foreseeable future, while National Grid expects a modest increase over last year. Therefore, both companies should continue to grow their free cash flow for the next few quarters.

Dividend policies
Now that we are familiar with the financial and cash considerations of dividend-paying utility stocks, we need some insight into their dividend policies. Investors need to know  how the companies' managers will return future cash earnings to their equity owners.

Below is a quick summary of the dividend policies for the five firms mentioned above, along with a short analysis of the actual status of these policies for the end of the latest reporting year:

Southern Company keeps it simple, targeting a dividend payout ratio of 65% to 70% of net income. For its latest fiscal year the payout ratio was above this target at 83%.

Progressive Energy states that it is committed to a long-term goal of a 70% to 75% dividend payout ratio. It actually paid out nearly 92% for its 2009 fiscal year.

National Grid doen't have a target ratio. Its CEO has publicly stated that the company intends to grow its dividends by 8% by 2012. For its year ending March 31, National Grid did not grow its dividends per share over the prior year.

Nstar also lacks a ratio target, but instead expects to grow its dividends at the same rate as its earnings growth. For 2009, dividends and earnings both grew about 7% for the year.

Exelon returns value based on prior years' performance. Right now, the company anticipates a modest increase in the dividend, and factors in share repurchases when considering its total cash return to shareholders. However, the total amount Exelon spent on dividends and share repurchases decreased in 2009 compared to 2008, while its number of average shares outstanding stayed flat.

As you can see, we have a trail mix of dividend policies, accompanied by a grab bag of different results from those policies' implementation. No single dividend policy is necessarily better than another.  However, there are preferences to look for. Compared to the vagueness of Exelon's policy, Fools should definitely prefer a clearly stated dividend stance. Also, investors should favor companies that follow through on their policy, like Nstar does. Keep in mind that while these traits are definitely welcome, dividend payers that don't follow them are not necessarily bad stocks.

Your utility player
When factoring dividend policies and the financial information above, Nstar and Exelon look like the best dividend plays for this group of utility stocks. I'd give the edge to Nstar, though. Both Exelon and Nstar are financially sound companies, but the latter's commitment to its dividend policy and free cash flow growth should keep investors smiling for the foreseeable future.