Investors new to dividend investing will see terms like Net Profit, EBITDA, Net Cash from Operating Activities, Free Cash Flow thrown around.
What are they? Where to pluck them from? Which one should you focus on when analyzing a dividend stock?
What is consider favorable and unfavorable cash management decisions?
We will clear this up today.
Why Net Profit, EBITDA, Operating Cash Flow and Free Cash Flow are Important Financial Metrics for us to Evaluate
When analysing whether a company for its dividend yield, your job is to assess whether its main sources of business are able to consistently generate healthy cash flow to pay your dividends.
- You do not want your dividends to be paid out always from its cash holdings because sooner or later, those cash will run out
- You want assess whether the company is borrowing money to pay your dividends. This is basically financial engineering to appeal to gullible dividend investors
- You want to assess whether its cash flow from its main businesses are growing such that in the future, your dividend payout will climb
- You want to assess what is a conservative dividend the company can pay under good times, bad times and neutral conditions.
Knowing the definitions of these terms, where to find them to analyse them, and how to make use of them are essential to dissecting businesses generating consistent dividends.
Annual Reports as a reference
It will be very difficult to explain without a good reference. We will use Starhub’s annual report for 2011 and SPH’s 2011 report as illustration.
[Link to Starhub full report here. Download it now as part of this tutorial >>]
[Link to SPH full report here. Download it now as part of this tutorial >>]
Dividends – The Cash Flow Payout to You as a Shareholder
The dividend is the basic way the company rewards its share holders. For a company to pay dividends it has to make use of its assets to earn income or cash flow.
Where can I find out the Dividend payout for the Work Year in an Annual Report?
You can find the dividends paid out for the work year under the Statement of Cash Flows – Cash Flow from Financing activities.
So now you know $343 mil, but how much dividend per share is that?
Under the Notes To The Financial Statements somewhere far far below the Statements of Cash Flow, you should find a section talking about dividends. Here you will see that this $343 mil pays out the $0.20 dividend, similar to 2010.
Net Profit / Net Income / Earnings Attributable to Shareholders
This is what most investors are concern about. You invest your cash in the company, the company goes out to buy assets that produce revenue after cost. The end result is that you get a profit.
As a dividend investor, you want to track past years Net Profit performance. The profit should be growing consistently.
Net Profit = Revenue – Operating Cost – Depreciation & Amortization – Interest Expense + Interest/Investment Income – Tax
This would include taking into account taxes paid, interest paid and received and depreciation of assets as expense. Basically what most analyst are concern with.
Where can i find this in the annual report?
You can find Income in 2 places. The first place is in the Income Statements. Some people evaluate based on profit before taxation while others take into consideration the taxes.
The second place is at the top of the Cash Flow statement. The net income will be use as a basis to calculate the EBITDA and overall cash flow which we will explain later.
EBITDA / Operating Cash Flow / Net Cash from Operating Activities
EBITDA or operating cash flow refers to the cash generated from the companies main core activities. Essentially this calculates the cold hard cash the main business brings in, which the management can user to carry out certain business decisions.
The difference between EBITDA and operating cash flow is that EBITDA does not take into consideration changes in working capital (your receivables, payables and inventories) and tax expense.
EBITDA = Net Profit + Depreciation & Amortization + Interest Expense – Interest Income + Tax
Operating Cashflow = Net Profit + Depreciation & Amortization – Interest/Dividend Income +Interest Expense +/- Change in disposable of plant and property + change in Receivables + change in Payables + change in Inventory – Tax Expense
Operating Cash Flow adds back items taken out from Net Profit (explained above) that are non cash related, or not dealing with its core business related.
Why is there a difference between Net Profit and Operating Cash Flow?
The reason why there is a difference is because the reporting in Singapore follows the GAAP accounting. It accruals income earned for services or goods delivered in this year.
However, this income earned my not be in cash but in IOUs such as receivables. There are also items paid as assets but are expense yearly over their workable life due to accrual accounting (depreciation and amortization)
As a dividend investor, you need to evaluate the ability of the company to come up with cold hard cash from core business, and thus evaluating whether EBITDA or Operating Cash Flow is healthy is important.
To learn more about accrual accounting versus cash accounting, you can read this article here.
Should I use EBITDA or Operating Cash Flow
The main difference between them is the change in working capital and tax expense. I tend to favor using Operating Cash Flow but will use them in conjunction.
In a healthy company, the change in working capital should be very very low. So your EBITDA should be close to your operating cash flow.
Things to watch out is where the operating cash flow gets bumped up massively because the company uses more payables which are not matched by receivables and inventories combined.
The payables are typically use for short term working purpose to balance short term financing for inventories and receivables.
In the past, we have seen cases where the payables are much more. The company use this short term financing to pay for the dividends. You will have to assess next year if that becomes a prevalent trend.
Where do I find them in the annual report?
The red box demontes the operating cash flow before working capital changes. Note that the depreciation and amortization and finance costs are added back to form the EBITDA.
The light blue box denotes the operating cash flow after factoring the working capital.
In the case of starhub the EBITDA and Operating Cash Flow is pretty close, indicating little use of working capital since there are limited inventories for telecom goods and services.
Why do we add back depreciation and amortization?
Depreciation and amortization is a GAAP accounting concept to expense assets such as plant, property and equipments used to produce goods and services according to their useful life.
But it does not result in cash flowing out. The cash for the asset is paid at the start of the purchase.
So there is no hard cash flowing out of the company. This cash can be used by the management for investments, paying dividends and retaining within the company
For many dividend stocks, depreciation and amortization can be very substantial. It is why the company can pay a dividend greater than Net Income.
The initial asset investment is very substantial. these includes:
- Network Infrastructure, Cell stations for Telecom companies
- Large power generation plants for utilities
- Long concession to operate ports (30-45 years)
- Long concession to operate toll roads (15-25 years)
- Leased land for industrial properties (30-60 years)
We will cover more of this in Free Cash Flow below.
Can additional cash flow come from other areas?
Yes. Note that operating cash flows account for mainly core business activities. A read up on the “Notes To The Financial Statements” would explain if that is the case.
The above cash flow statement belongs to SIA Engineering. SIA Engineering engages in many joint ventures and the gem of it is that these joint ventures generate a sizable cash flow.
The Dividends received from them is such that is almost equivalent to the operating cash flow. For such companies, to calculate whether the cash flow produce by the business can sustain the dividends, I would factor in this to my dividend sustainability computation.
Here is another example. This is the cash flow statement – investing activities section of Singapore Press Holdings (SPH). SPH’s stake in M1 and Starhub generates recurring dividends to the tune of an average 40 mil per year. This is recorded in the Investing Activities of the cash flow statement.
Free Cash Flow / Owner’s Earnings
So we have Net Income, EBITDA and Operating Cash Flow, why do we need to calculate Free Cash Flow?
We need that because Operating Cash Flow do not factor in the capital expenditure requires to maintain the plant, properties and intangible assets required to continue generate goods and services.
Note that we added back depreciation and amortization to form operating cash flow. It will be great that the plant, equipment, concessions mentioned in Depreciation and Amortization can go on forever!
The way Warren Buffett likes to think about the cash flow question is to think about “owner earnings”. If a company produces a certain amount of cash during the year, how much would the owner need to send back to that company’s management for them to keep sales, profits, etc. the same next year and next year and next year. Can we imagine a sort of “steady state” of capital spending that would keep profits about the same in the future as they are today.
But alas, they will break down. To ensure the company can continue indefinitely to operate and produce goods and services, capital expenditure needs to be spent and deducted from Operating Cash Flow
To know more why this is a pretty appealing cash flow you can read Geoff Gannon’s post here.
Where can i find the capital expenditure on the annual report?
The capital expenditures are recorded in the Statement of Cash Flows, under the Cash Flows From Investing Activities.
For large company like SPH, their investing section is littered with capital expenditure for maintenance as well as investments. It also consists of dividends received from investments, short term or long term investments bought or sold.
The box in light blue are the line items indicating capital expenditure for maintenance. A healthy company would have adequately cover this portion with its Operating Cash Flow.
The red box indicates line items for capital expenditure for investments. This is usually funded by debts, new issuing of shares /equity but also in some cases from operating cash flow if the company do not pay out large amount of dividends.
What else does Free Cash Flow missed out on?
While Free Cash Flow takes into consideration many things, it still misses out on Interest Expense and Dividends and Earnings from Joint Venture explained above.
For highly leverage companies, their interest expense is substantial, and it reduces the amount that is left over to pay for dividends.
For some companies, such as SIA Engineering and SPH, dividends from investments can be substantial and forms a long term holding in their business model that you need to consider them as positive cash flow.
You can find the Interest Expense under the Cash Flow statement – Cash Flows from Financing Activities, Interest paid
Why Separate Maintenance Capital Expenditure from Investment Capital Expenditure?
I tend to look at capital expenditure as 2 kinds, the part that maintains current growth (maintenance) and the part that provides incremental growth (investments).
The maintenance capital expenditure is to offset depreciation of current equipment to ensure long term serviceability to produce the current level of goods and services. It is viewed as mandatory and likely recurring in effective operations and there fore should be part of Free Cash Flow calculations.
The investment capital expenditure is a business decision undertaken to ensure the company take advantage of opportunities and strength to expand. This is likely to fluctuate and in down times, the focus may shift away from this.
For such investments, leverage and cash calls can be logical financing methods to fund growth.
Thus, as dividend investor, to ascertain the sustainability of dividend payout over a period of time, we usually factor in the maintenance portion of capital expenditure.
Free Cash Flow = Operating Cash Flow – Maintenance Capital Expenditure
Summary and Making Sense of it All – Cash for Capital Management
So now that we explain the definitions, formula and where to find them in the annual report, lets relate to them.
- The Free Cash Flow is the safest published measure of whether in a work year, whether a company like SPH is paying within their means. Here its Free Cash Flow of 513 mil is more than cover for 433 mil for its $0.27 per year dividend
- The Free Cash Flow is less susceptible to financial engineering such as shift operating expense to capital expenditure because capital expenditure (27 mil) is deducted from the Operating Cash flow
- We introduce a Cash for Capital Management (grey bar). As mentioned in Free Cash Flow, this still misses out on the earnings from Investments, Joint Venture and Subsidiaries as well as Interest on Debt. Effectively, this Cash for Capital Management is what is left to be paid out as dividends, pay of debts, buy back shares
- In my opinion, after factoring additional income and interest expense, Dividends less than Cash for Capital Management is the benchmark we should use to ascertain whether a company is paying its dividends within their means
To sum it up, an Investor can calculate this from the annual report by:
Cash for Management = Operating Cash Flow – Maintenance Capex – Interest Expense + Dividend Inflow from Investments, JV and Subsidiaries
To help you guys again, here is where you can find them:
What are signs of healthy and unhealthy cash flows
Different companies have different capital management structure based on the stage of growth and the nature of the business.
I compiled a list of what I think are favourable cash management versus unfavourable:
1. Dividend payouts, Repayment of debts, Buy Back of shares should be less than Cash for Capital Management
These 3 are healthy business decisions that rewards the share holders. While we expect that in some years dividend payout is larger than the cash inflow from business, they should largely be inline. The key take away is that they should come from the business and not from debts or other forms of financial engineering
2. Changes in Working Capital net net should be low
There can be one or two years where inventories and receivables built up. Balancing these with payables is good. But when payables are consistently high compare to receivables and inventories, you have got to dig further why it is like this
3. Company should be conservative in paying out of depreciation. Depreciation should be matched by Maintenance Capital Expenditure
There are many business trusts such as HPH, MIIF or CMPacific who pays out or has underlying assets that pay out of depreciation.
In the case of SPH here, you see that the Maintenance Capital Expenditure more or less matches that of Depreciation.
Properties and plants will eventually wear and tear and need replacements, and concessions to operate will expire. A company should horde this portion of cash and be ready to replenish them.
By paying out the cash from deprecation just to satisfy investors, they are bracing for unknown risks that would require a subsequent cash call just to buy the plants to replace the old ones, and to renew the land lease (REITs) or concessions (Toll Roads, Ports)
4. Company should pay off debts instead of satisfying investors thirst for dividend
Some companies know that investors like high yield, so they pay out and roll over debts or interests. They get into trouble when credit becomes difficult to get and they have problems refinancing, or have to refinance at a very expensive interest rate.
This eventually becomes a burden on the share holders as they need to bail the company out or they get a much smaller dividend in the future.
The smart thing is to do what SPH does to slowly pay off the debts. From the chart above, SPH paid off 320 mil utilizing its excess cash from businesses and its cash holdings.
5. Cash Flow from Business should be growing. Do not get suckered by one time large dividend payout
Analysing the business nature and cash flow & income growth will tells us a bit or two on whether the cash flow in the future will grow.
Analyse across 5 to 10 years of data. Do not use only one year because you may have just analyse a year where the business did exceptionally well. That kind of income will not be revisited always.
The best is that there are visible figures showing good business model translating to consistent growing cash flows.
6. Ask questions about the cash flow based on future business outlook
Some questions to ask:
- What is a conservative dividend payout? Will you be satisfied with it?
- Factoring competition, opportunities and potential substitutes, how will it affect the cash flow?
I hope that clears up most of the thing. To make sense of the cash flow of the business is imperative not just in Dividend Investing but general Fundamental Analysis.
Dividend is just one reward, there are many other ways.
At the end of the day we are cash flow investors, and we invest in sustainable growing cash flows.
I found a few articles that explains these cash flow better than I do. I will link them below do take a look at them.
Do let me know if you have any questions.
Good Articles on Cash Flow
- Free Cash Flow vs Owner’s Earnings: Which matters more. Geoff Gannon’s article talks about why Warren Buffett sees this as a better measure than net profit, the role of maintenance capital expenditure over others
- Understanding Depreciation: 4 Depreciation Archetypes. Geoff Gannon explains different types of depreciation and how important are they
- Debt and Taxes in Dividend Investing: Not all debts are bad. You have to understand the context of the debt for the company you are looking into. In some cases the savings for the shareholders is good.
- Case Study: APTT’s 12.5% Dividend Yield. The cash flow from operation does not cover the dividend. We take you through how to compute the free cash flow and assess whether the cash flow covers the dividend.