Is Clorox's Dividend Safe?

Clorox has a long line of dividend payments streaming behind it, which gives many investors peace of mind. Photo: Flickr via Mike Mozart.

A long, consistent history of dividend payments gives investors insight into the strength and financial well-being of a company. Clorox (CLX 1.24%), for example, has paid investors a dividend for 46 consecutive years and has raised the payout annually since 1977.

You can't rely upon history alone, though, because history is replete with companies that cut or suspended their payouts after recording decades of reliable payment. For example, Barnes & Noble (BKS), General Motors (GM -0.04%), Citigroup (C -0.32%), and Eastman Kodak (KODK -1.93%) all had storied histories of consistent dividend payments, but were forced to slash and then halt them due to changing business circumstances.

However, there were signs beforehand warning investors of trouble on the horizon.

GM's dividend yield, for example, soared to over 10% in 2005 even though the payout remained stable. That occurred because the carmaker's stock price was crumbling due to  serious production and sales issues. Soaring digital camera sales eviscerated Kodak's film-based business, portending future doom. Keeping an eye on their business could have protected investors from the shock of an endangered dividend.

Even so, dividend history remains a useful yardstick for measuring a stock's prospects, and smart investors examine a company's ability to make the quarterly payment.

One tool used to do so is the payout ratio, which is calculated by dividing the number of dividends per share a company pays by its per-share earnings. Expressed as a percentage, lower is generally better, and any company with a ratio exceeding 100% is paying out more in dividends than it makes in profits.

Typically, a payout ratio below 75% is considered safe, but lower percentages give a company room more to increase its dividend in the future.

Clorox's dividend of $2.96 per share currently yields 2.9% annually on trailing earnings of $3.89 per diluted share. That gives it a payout ratio of 76%, which pushes it to the upper limits of comfort.

The company's cost-savings programs is achieving the desired result, and Clorox is experiencing higher volumes and rising sales as a result of price increases. Still, the business is still turning around, so it saw $0.08 per share swiped from earnings  this quarter from the continued implementation of incremental demand-building initiatives. That should change in the future as these programs pay off.

CLX Payout Ratio (TTM) data by YCharts.

Another tool investors use to determine a company's payment capacity is the dividend coverage ratio, which flips the previous calculation by dividing EPS by a company's dividends per share. Called the coverage ratio, a result of two or three is seen as safe and indicates the company can pay dividends that are two to three times higher than the current rate. A higher ratio might suggest a company is hoarding its cash and not returning enough to investors, while one consistently below 1.5 could signal difficulty in maintaining its payout.

Clorox's dividend coverage ratio is 1.3, also seemingly a warning sign, but investors shouldn't be too concerned yet.

Clorox is beginning to generate strong free cash flow again. As it struggled to reformulate itself, Clorox's free cash flow fell from $616 million in 2010 to $420 million two years later, a 17% annual decrease. That was even as the dividends it paid out over those two years jumped more than 8% annually.

Now the situation is reversed and free cash flow is on the rise. For fiscal 2014, Clorox's free cash flow was 8.3% higher than a year ago and 50% higher than its nadir in 2012, while over the trailing 12-month period free cash flow was 65% higher than that low point. As profitability continues to improve, the risk that Clorox won't be able to make its payouts recedes quickly.

Data: Morningstar.com.

Clorox's portfolio of brands cover a broad range of household needs, and its bleach that is virtually synonymous with the industry -- it owns over half the market share. Moreover, more than 80% of the products in its portfolio are the top one or two brands of their respective segments.

This stock might not be the cheapest on the market at the moment, but income investors who are holding shares and wondering if there's a reason for concern their dividend checks might be reduced -- or even halted -- can sleep soundly in the expectation that these payouts will continue uninterrupted.