LONDON -- Many investors focus on earnings per share when judging a company's performance. However, earnings can be manipulated and adjusted in all sorts of ways, meaning they don't tell you a lot about how much spare cash a company has generated. Similarly, since dividend cover is calculated using earnings, a good level of dividend cover doesn't necessarily mean the payout is actually being funded from a company's profits.
A company's cash flow can tell you a lot about a firm's financial health. Is the company burning up its cash reserves on interest payments and operating expenses, or does it generate spare cash that can fund dividends or be retained for future investment? If a dividend isn't funded by cash flow, then there is a greater chance the payout will become unaffordable and be cut, which is bad news for shareholders like you and me.
In this series, I'm going to take a look at the cash flow statements of some of the biggest names in the FTSE 100 to see whether their dividends are being funded in a sustainable way, from genuine spare cash. Today, I'm looking at RSA Insurance Group , the 300 year-old general insurance company previously known as Royal Sun Alliance.Does RSA have enough cash?
As private investors, we want to back businesses that are able to pay their dividends out of free cash flow each year. I define free cash flow as the cash that's left over after capital expenditure, interest payments, and tax deductions. With that in mind, let's look at RSA's cash flow from the last 4.5 years:
|Free cash flow (£m)||81||-294||411||285||331|
|Dividend payments (£m)||189||198||248||321||202|
|Free cash flow/dividend*||0.4||-1.5||1.7||0.9||1.6|
RSA's cash flow statements provide a good example of how a dividend can be reliably covered by earnings, but not by cash flow. By my calculation, RSA's dividends have only been covered by free cash flow an average of 0.6 times over the last 4.5 years, meaning that 40 pence of every pound paid in dividends has come from cash reserves or borrowed funds.
Although this isn't something I like to see in a company, in RSA's case it isn't too alarming, since the company has maintained a cash balance of greater than 1 billion pounds throughout this period. What's more, judging from its 2012 half-yearly report, this insurance giant generated cash strongly last year, as its cash balance rose by 135 million pounds to 1,376 million pounds during the first half of 2012.
A 7% dividend yield?
Now we've established that RSA can comfortably afford its dividend payments, we need to question why its 7% yield is so high -- after all, it's more than double the 3.3% average of the FTSE 100. The short answer is that since it peaked in 2007, RSA's share price has drifted downwards to a low of about 98 pence in June 2012, thanks to a combination of falling profits and the effects of the eurozone crisis.
RSA's share price didn't suffer as badly as its peer Aviva, however, thanks to a much lower level of exposure to the government debt of the eurozone's troubled PIIGS nations. At the end of 2011, the last point for which figures were available, Aviva held 1.3 billion pounds of government debt issued by Portugal, Italy, Ireland, Greece and Spain, while RSA only held 138 million pounds of government debt from these countries, reducing its exposure to the worst risks in the eurozone.
Also unlike Aviva, RSA continued to increase its dividend throughout the financial crisis, resulting in a dividend yield that peaked at nearly 9% last year. Since then, RSA's dividend yield has fallen to around 7% because of a 35% rise in the company's share price.
Is RSA's dividend safe?
RSA's earnings per share hit a low of 9.7 pence in 2010, before rebounding to 11.8 pence per share in 2011. RSA hasn't yet published its full-year results for 2012, but its half-year results suggest that this year's earnings may be similar to last year's, while the company's cash balance has risen to 1,376 million pounds.
Overall, I think that RSA's dividend looks pretty robust and is likely to continue to grow steadily over the next couple of years, making the company's shares an attractive contender for an income portfolio.
2013's top income stock?
The next few years are likely to bring new laws and regulations that will affect the U.K.'s utility sector. If you are interested in building a holding of high-yielding utility shares, then I would strongly recommend this new report from the Motley Fool's expert analysts, who have looked closely at the U.K.'s utilities and found one share they believe will be the best income opportunity in 2013.
The company in question offers a 5.7% dividend yield, and the Fool's analysts believe that it could be worth up to 850p per share -- offering new investors a potential 20% gain on the current share price.
Indeed, the Motley Fool's analysts are so confident in this share that they've named their report, "The Motley Fool's Top Income Stock For 2013"! This exclusive new report is completely free, but it will only be available for a limited time -- so click here to download your copy now.
The article Where Next for the RSA Insurance Group 7% Dividend? originally appeared on Fool.com.Roland owns shares in Aviva but does not own shares in RSA Insurance Group. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.
Copyright © 1995 - 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.