In focusing on earnings per share growth rather than on dividend growth, investors have traditionally made two big assumptions—(1) that dividend payout ratios would remain constant and (2) that earnings retained after dividend payouts would lead to higher future dividends at a rate equal to the earnings growth rate. Although, under the accounting and financial policies that prevailed until the early 1970’s, these assumptions were fairly realistic, earnings per share figures are no longer reliable approximations of the cash available to pay earned dividends, finance future growth and reduce debt.
While valuation models focusing on earnings per share growth have thus lost much of their usefulness, the source of dividends remains the same—real cash, or the potential to generate real cash. If earnings has become a less useful proxy for a company’s dividend potential, the investor must pay less attention to earnings and more attention directly to the source of dividends.
To assist the investor in focusing on potential to generate cash, the author introduces what he calls the Total Cash Flow Analysis Statement. Viewing corporations in terms of this statement reveals that corporate liquidity is high, cash flow from the operating cycle strong and sustainable, capital expenditures and dividend coverage ratios improving, and debt to equity ratios declining. Under these circumstances, those companies that have not already done so are likely to increase dividends.
While the market may already be paying more attention to dividends, it probably does not yet fully comprehend the extent of the improving cash flow situation.