Question

• Earnings (EPS) and cash flows will both matter for your firm. Sometimes, a given decision will help one but harm the other. How do you strike the right balance in such decisions? Explain your reasoning

Answer 1

The quick and clean method of determining a dividend's safety is by the payout ratio. The payout ratio is calculated by taking the dividends per share and dividing it by the earnings per share (EPS).

It's fairly easy and straight-forward and can be found on just about any financial website. Of course there's all sorts of variations on the payout ratio as you can take the trailing twelve months payout ratio, forward twelve months payout ratio, a blend of the two... The only thing that changes between those is what kind of dividends and earnings per share you're using, the calculation is the same. But for some industries the traditional method just isn't all that useful.

Let's start with the difference between earnings per share and free cash flow per share. Earnings are derived from the net income of a company. Essentially you take the revenue of a company subtract certain expenses such as administrative, depreciation, interest expenses, cost of goods, taxes, and a whole host of other items. That leaves you with the net income for that company and to get the earnings per share you just divide by the shares outstanding. All earnings per share information and calculations can be found on a company's income statement.

Free cash flow on the other hand is a bit different. You start with the net income from before but you have to add back some items that aren't cash expenses, such as depreciation and amortization. This will give you the operating cash flow of a company and the free cash flow is calculated by subtracting the capital expenditures (Capex, "purchase of plant, property, equipment").

Let's run through an example to see what the difference is on earnings and free cash flow. We'll assume a company needs to purchase a truck in order to deliver its goods. The company has a net income of $20,000 each year and the truck costs $10,000. To follow standard accounting practices the truck will be depreciated over a 4 year period, its assumed useful life, at 25% of the cost per year.

Year	Net Income	Free Cash Flow
1	$20,000	$10,000
2	$17,500	$20,000
3	$17,500	$20,000
4	$17,500	$20,000
5	$17,500	$20,000
Total	$90,000	$90,000

So in year 1 the company had to spend $10,000 to purchase the truck. You wouldn't know it from looking at the income statement but there it is showing up on the cash flow statement as capex. So there's a $10,000 difference between the net income (earnings) and free cash flow for the company in year 1. When year 2 rolls around net income will show a depreciation charge of 25% x $10,000 = $2,500 where as cash flow is no longer effected. This will continue on until the depreciation period is up and then net income and free cash flow would be equal in this simple example.

For companies with large capital expenditures (think telecoms like AT&T and Verizon or utilities like PPL and Southern Company), depreciation charges can be very significant and lead to large differences in the earnings and free cash flow that a company generates.

Let's look at Verizon's financials from the last few years. Keep in mind this isn't the end all be all of reading a financial statement, but I just want to highlight a few of the key differences between the balance sheet and income statement and their effect on earnings and cash flow.

Figure 1: Balance Sheet, i.e. earnings per share

Figure 2: Cash flow

Depreciation and amortization charges are non-cash charges so they don't effect the cash flow year after year. You'll notice a big difference between the earnings per share numbers and the free cash flow per share numbers. In 2012 Verizon had only $0.31 per share in earnings but a huge $3.97 per share in free cash flow. That's over a factor of 10 difference. 2011 wasn't on quite the same scale but it was still $0.85 in earnings but $4.77 in free cash flow. That's a difference of over 5.5 times. 2010 saw 6.6 times higher free cash flow than earnings per share.

So how does this effect a dividend growth investor? If you look at the traditional calculation of the payout ratio, dividends divided by earnings, it appears that Verizon's dividend is surely going to be cut. So you might shy away from investing money in a stable company like Verizon.

Figure 3: Payout ratios

The payout ratios were over 200% in both 2010 and 2011 and a whopping 664% in 2012. That doesn't seem sustainable in the least bit. But remember, depreciation charges are a drag on earnings over the expected useful life of the property, plant or equipment that was purchased, whereas it's a one time charge to the cash flow.

Recalculating the payout ratio as dividends divided by free cash flow paints a much different picture. The FCF payout ratio has increased from 30% in 2010, to 41% in 2011, to 51% in 2012. That's much different than the 203%, 234%, and 664% from the earnings per share payout ratio.

For companies that are very capital intensive, the earnings per share and free cash flow numbers can vary greatly. You need to make sure that you're using the right payout ratio when analyzing the safety of a potential investment because the wrong one can lead to wildly different conclusions.

*Keep in mind that there are many other factors to consider before investing your hard earned money than just calculating the payout ratio of a company and that this is in no way an all-inclusive lesson in reading financial statements.