Among the six oil and gas equipment and services companies in the S&P 500, four pay out a dividend. Out of those four, National Oilwell Varco (NOV) has the highest dividend yield at 4.6%. Recently, energy companies have either cut their dividends (Noble (NE), Transocean (RIG)) or come under scrutiny for maintaining high yields (Kinder Morgan (KMI)).
I'm tempted to discover how sustainable NOV's dividend is. To test dividend sustainability, investors should examine the company's payout ratio, trailing 12-month free cash flow compared to next 12-month dividends and return on equity.
While NOV's payout ratio, or percentage of earnings paid out in the form of dividends, has climbed over the past three years, it remains at a modest 50% on a trailing 12-month basis. The previous two quarterly payout ratios were 60% and 75%, which points to a higher trailing 12-month payout ratio over the next two quarters. Despite this, NOV is clearly earning enough to pay dividends.
In terms of free cash flow, price declines in energy have helped reduce trailing 12-month free cash flow from $3 billion in the second quarter of 2014 to $891 million in the third quarter of 2015. Compared with a projected 12-month dividend payout of $714 million, there's still room for NOV to pay dividends from free cash flow. A poor performing quarter, however, could drop free cash flow below that threshold.
The sustainable return on equity is determined by multiplying the dividend yield by the price-to-book ratio. With NOV, a price-to-book ratio of 0.83 actually helps lower ROE requirements since the market cap is below book value. NOV's required return on equity is 3.85%. In the third quarter, NOV's ROE was 8.8% -- which is clearly enough to pay the dividend.
Overall, NOV passes the payout ratio and return on equity tests with flying colors. Investors should continue to monitor cash flow in future earnings reports as it is the closest threat to dividend sustainability. Despite this, it is quite impressive that an energy company has such low valuation with a sustainable dividend.