There are many different things to consider before buying an ownership interest in a publicly traded company. These include the business model, valuation, and historical earnings growth. Another important consideration is the dividend. It's important to remember that from 1930 to 2012, dividends accounted for about 42% of the gains in the S&P 500.
Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. Most of them prefer to diversify into many different sectors of the economy in order to spread out their risk.
Today, let's take a look at 3M (NYSE:MMM), a huge conglomerate in the industrial sector of the economy. Let's see how 3M's dividend stacks up in terms of strength and sustainability.
The first and most obvious consideration when evaluating a company's dividend is the dividend yield, which represents the percentage of your investment that you'll receive back over the next 12 months at current share prices and dividend payouts.
3M currently yields 2.6%. This yield is actually a forward yield, based on the company's recent 35% dividend hike. The dividend yield is currently at its highest level since the end of 2012. Over the past five years, the dividend yield has ranged between 1.8% and 4.1%.
It should be mentioned that the 4.1% yield occurred in March 2009, when the yields of many stocks, including 3M, were inflated due to the downturn in the broader market that resulted from the financial crisis. For this reason, I don't think that investors should expect to see yields like that in 3M anytime soon.
When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation, as well as to show confidence from management in the company's outlook.
Over the last five years, 3M has increased its dividend by an average of 11.4% each year. However, this average is skewed a bit by its most recent increase of 34.6%, back in December of last year. Up until that point, dividend growth had ranged between 3% and 7.5% over the last five years. These dividend growth rates easily outpace inflation, which currently sits at around 1.6%.
3M has increased its dividend every year for the last 56 years. There are very few companies who can claim such a long streak of sending money back to shareholders. This streak is longer than that of fellow industrial companies, United Technologies (20 years) and Illinois Tool Works (39 years). It is even longer than the dividend growth streak of the revered Johnson & Johnson, which sits at 51 consecutive years.
This long streak of dividend increases lands 3M in the list of S&P 500 Dividend Aristocrats, an elite group of companies who have increased their dividends for at least 25 years straight.
The good yield and strong history of dividend increases illustrate the commitment of 3M when it comes to returning cash to shareholders. The company has paid dividends uninterrupted for over 97 years.
Free cash flow payout ratio
While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better, as they leave more room available for future dividend increases or other uses of the capital.
Free cash flow is the cash flow a company generates in its operations minus capital expenditures.
Over the last 12 months, 3M has paid out 42% of its free cash flow to shareholders in the form of dividend payments. This percentage is in line with what the company has done over the last four years. Its four-year average free cash flow payout ratio sits at just 40%. This is a very healthy payout ratio, which leaves plenty of room for future dividend increases along with other value-creating activities.
While the company's trailing-12-month, free cash flow payout ratio is very low in absolute terms, I expect this value to rise a bit after the company's 35% dividend hike. However, based on where the ratio was before this increase, I don't see any reason why the new dividend can't be sustained.
Earnings per share growth forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth. This year, analysts expect 3M to increase its earnings per share by 11%, followed by a 10% increase in 2015.
Earnings per share growth in the 10% range should be more than enough to maintain the dividend going forward, as well as support dividend increases in the future.
The stock of 3M currently has a reasonably attractive dividend yield. The company has shown a strong commitment to returning cash to shareholders through its 56-year streak of dividend increases and its nearly 100-year history in uninterrupted dividend payments. Its free cash flow payout ratios over the last several years show that the company's dividends have been well-supported by free cash flow, and that this trend, along with strong dividend growth, should continue in the years to come.
David Schauber has no position in any stocks mentioned. The Motley Fool recommends 3M, Illinois Tool Works, and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson. 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.