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How Safe Is IBM's Dividend?

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Since bottoming in late December, shares of IBM (NYSE: IBM) have surged by more than 31%, thanks in part to an overall market rebound as well as a positive market reaction to the company's most recent earnings results.

Although the company's dividend yield has come down significantly as a result of the large rebound in the stock price, investors who pick up the shares today can still enjoy a robust 4.6% dividend yield based on the company's current dividend payout.

The question you might have, then, is this: Is IBM's current dividend sustainable, or is that large yield simply a trap?

Artist's rendering of clouds connected by lines.
Artist's rendering of clouds connected by lines.

Image source: Getty Images.

A safe dividend

To gauge the sustainability of a company's dividend, one metric that investors should take a look at is the company's free cash flow per share on a trailing-12-month basis. The idea here is that if a company generated significantly more free cash flow over the last 12 months than it paid in dividends over that time, then there's a good chance that the current dividend is sustainable.

In IBM's case, the company turned in $12.58 in free cash flow over the last 12 months and paid out dividends of $6.28, so it's clear that Big Blue generated far more than enough cash to cover the dividend over that time.

With that being said, past performance doesn't always guarantee future performance. So, the next thing we need to look at is the company's free cash flow forecast for the coming year.

IBM Dividend Chart
IBM Dividend Chart

IBM Dividend data by YCharts

The good news is that the company forecasts free cash flow of "approximately $12 billion" for the year, which, based on the company's share count at the end of its most recent quarter, should translate into free cash flow per share of around $13.20. That's more than enough to pay out the current dividend and even allow for another increase. (IBM generally increases its dividend every four quarters, so it's due to raise its dividend the next time it declares one.)

What about IBM's Red Hat acquisition?

Late last year, IBM announced that it would be buying cloud software maker Red Hat in a deal worth $34 billion. You might be concerned that because IBM is making such a large purchase, it won't be able to sustain its current dividend -- but you shouldn't be.

Management explicitly indicated in the deal announcement that the acquisition would be "free cash flow and gross margin accretive, accelerate revenue growth and support a solid and growing dividend."

So, unless catastrophe strikes the business, investors shouldn't worry that the company's big Red Hat buy is going to compromise their IBM dividend checks. In fact, if the deal ultimately works out as IBM hopes, the company's free cash flow should get a significant boost, potentially helping the company's dividend growth over time.

The capital returns sacrifice that IBM will be making as a result of this deal, though, is that the company plans to halt its significant share repurchase program in both 2020 and 2021 in order to keep its credit rating where it wants it.

Investor takeaway

If you're an IBM investor and you're invested in the company in part because of the large dividend and the prospects for steady dividend growth out in time, then you need not worry -- the dividend looks like it's here to stay and, over time, keep growing.

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Ashraf Eassa has no position in any of the stocks mentioned. The Motley Fool is short shares of IBM. The Motley Fool has a disclosure policy.