The ability to calculate the reliability of dividends is absolutely crucial for investors, not only for evaluating the income generated from your portfolio, but also to avoid a share-price collapse from stocks where payouts are slashed.
There are a variety of ways to judge future dividends, and today I am looking at British American Tobacco (LSE: BATS) (NYSE: BTI.US) to see whether the firm looks a safe bet to produce dependable payouts.
Forward dividend cover
Forward dividend cover is one of the most simple ways to evaluate future payouts, as the ratio reveals how many times the projected dividend per share is covered by earnings per share. It can be calculated using the following formula:
Forward earnings per share ÷ forward dividend per share
British American Tobacco is anticipated to produce a dividend of 146.1p per share in 2013, according to City forecasters. With earnings per share expected to come in at 225.3p for this year, the dividend is covered 1.5 times, short of the widely-regarded safety benchmark of 2 times forward earnings.
Free cash flow
Free cash flow is essentially how much cash has been generated after all costs and can often differ from reported profits. Theoretically, a company generating shedloads of cash is in a better position to reward stakeholders with plump dividends. The figure can be calculated by the following calculation:
Operating profit + depreciation & amortisation - tax - capital expenditure - working capital increase
The tobacco giant's free cash flow dipped to £3.55bn in 2012 from £3.81bn in the previous 12 months. This was mainly owing to a meaty increase in capital expenditure -- net outlay rose to £742m last year from £566m in 2011. A solid rise in working capital, to £282m from £141m, was also a notable contributory factor.
This ratio is used to gauge the level debt a company carries. Simply put, the higher the amount, the more difficult it may be to generate lucrative dividends for shareholders. It can be calculated using the following calculation:
Short- and long-term debts + pension liabilities - cash & cash equivalents
___________________________________________________________ x 100
British American Tobacco's financial gearing clocked in at 84.3% in 2012, up markedly from 69.3% in the prior year. The result was compounded by a large increase in net debt, to £8.47bn from £7.93bn in 2011. Cash and cash equivalents also dropped to £2.08bn from £2.19bn during the period.
Buybacks and other spare cash
Here, I'm looking at the amount of cash recently spent on share buybacks, repayments of debt and other activities that suggest the company may in future have more cash to spend on dividends.
The tobacco giant has embarked on a huge share repurchase scheme in recent years, and bought back £1.25bn worth of shares last year, up from £750m worth in 2011. And the firm plans to increase repurchases to £1.5bn in 2013.
In addition, the company is also investing massive sums to bolster its global operations, particularly in the lucrative emerging regions of Asia-Pacific. With four-fifths of tobacco demand originating from these geographies, I expect British American Tobacco to keep capital expenditure moving higher to latch onto this juicy potential.
Roll up for excellent dividend potential
At face value the metrics discussed above seem to suggest declining virtues for British American Tobacco's appeal as a solid dividend pick. However, British American Tobacco has continued to keep dividends moving higher in recent years amid solid earnings improvement, its position in the defensive tobacco sector negating potential fears over the bottom line and consistently below-par dividend cover.
The projected 2013 payout carries a yield of 4.3% -- far ahead of the 3.3% FTSE 100 average -- and I believe that the prospect of chunky earnings expansion, helped by healthy capex flows, should result in increasingly-generous dividends over the medium-to-long term.
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