To become a Dividend Aristocrat, a company has to increase dividends for at least 25 straight years. When a company makes this list and also becomes a de facto economic indicator, investors should take note. With Automatic Data Processing (NASDAQ:ADP), stockholders get not only a company that has increased dividends for 38 years, but a good indicator about the health of the job market at the same time.
A business everyone needs
ADP is one of a few large players in the payroll processing industry. The company competes with Paychex (NASDAQ:PAYX) and Intuit (NASDAQ:INTU), which provide different levels of service to customers.
ADP has agreements with many banks that cross-sell ADP's payroll services as part of their banking packages. Paychex seems to focus on smaller business customers and it competes on pricing. Since Intuit isn't normally taking the payroll off the company, its software solution allows the business owner to keep control and it is normally much cheaper than an outsourced solution.
The good news for investors is that ADP and its competition are needed by thousands of businesses. Since businesses will always need payroll processing, as the domestic economy continues to recover, these companies will benefit.
Can they afford to pay?
Just because a company has paid and raised its dividend for 38 years doesn't mean that investors should automatically assume that this will continue in the future. When looking at a company's ability to afford its dividend, investors need to look at free cash flow.
However, even when it comes to cash flow, investors need to look at what I call core cash flow to get a sense of what the company can return to investors. Core cash flow is simply net income plus depreciation, minus capital expenditures. This metric helps investors filter out non-cash-related items.
In the last three years on average, ADP generated roughly $1.6 billion per year in core free cash flow. During this same time frame, the company paid an average of nearly $750 million in dividends. Looking at these numbers, the company's core free cash flow payout ratio was just under 48%.
By comparison, Paychex's core free cash flow payout ratio was more than 78%, while Intuit generated a payout ratio of under 22%. If we look at a shorter time frame, ADP kept up its consistent performance with a payout ratio under 50% on average in the last four quarters.
It seems pretty clear based on these numbers that ADP can not only afford its current dividend, but that its payout ratio is very close to the average of the last few years.
What about growth?
It's one thing to find a company that can afford its current dividend. If the dividend isn't growing, the stock's returns may trail its peers'. In the last five years, ADP's dividend growth slowed down going into 2009 and 2010, but it has since recovered.
As you can see, the company's dividend growth in the last two years averaged better than 8%. During this same time, ADP's average core free cash flow has been better than 6.5%. Since free cash flow has nearly kept up with dividend growth, investors should reasonably expect that ADP's future dividend growth should be close to expected earnings growth.
Great business, with one potential problem
In the next five years, analysts expect ADP to report earnings-per-share growth of nearly 10%. For comparison, Paychex is expected to grow earnings by about 10% and Intuit is expected to grow faster at more than 14%.
If there is one problem with the ADP story, it's the fact that the stock isn't cheap by historical standards. In the last five years, the stock's highest P/E ratio was almost 25, and today the stock trades for a P/E of almost 24. Though Paychex trades for a higher P/E ratio, Intuit is expected to grow faster and yet trades for a lower ratio.
It's possible that ADP's relatively high P/E is warranted based on the expectation that the domestic economy will continue to recover. However, the stock seems to already reflect this optimism. If you want to keep up with developments with ADP, consider adding it to your personalized Watchlist. The company should continue its 38-year streak of dividend increases, but investors might want to wait for a pullback in the stock before investing.
Fool contributor Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Automatic Data Processing, Intuit, and Paychex. The Motley Fool owns shares of Intuit and Paychex. 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.