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In today's difficult macro environment, challenging credit markets, and the low interest rate environment, it is tough to find attractive dividend plays.

To create the list below we began by screening the S&P 500 for dividend stocks paying yields between 1-5%, and with sustainable payout ratios below 50%. We excluded stocks with yields above 5% so that we could avoid the riskier names.

Additionally, we looked for companies that appear undervalued relative to their cash flows, indicated by high ratios of levered free cash flow/enterprise value. Levered free cash flow plays an important role in paying for dividends and further expansion of the business.

Levered free cash flow is the free cash flow after deducting interest payments on outstanding debt. Enterprise value is the sum of the firm's value from all ownership sources: market cap, outstanding debt, and preferred shares. When companies have ratios of levered free cash flow/enterprise value in excess of 10%, it may indicate that the company as a whole is being undervalued.

This ratio gives us the money that the business can use to grow and pay dividends to shareholders. Any possibility of a dividend payout nowadays is looked at positively.

Finally, we screened that universe for those that appear undervalued relative to the Graham Number. The Graham Number is a measure of maximum fair value created by the "godfather of value investing" Benjamin Graham.

It is based on a stock's EPS and book value per share (BVPS).

Graham Number = SQRT(22.5 x TTM EPS x MRQ BVPS)

The equation assumes that P/E should not be higher than 15 and P/BV should not be higher than 1.5. Stocks trading well below their Graham Number may be undervalued.

The List

Our final list consisted of 6 stocks.

For aninteractive version of this chart, click on the image below. Analyst ratings sourced from Zacks Investment Research.

Do you think these stocks should be trading higher? Use this list as a starting point for your own analysis.

1. AFLAC Inc. (NYSE:AFL): Provides supplemental health and life insurance.

  • Market cap at $23.28B, most recent closing price at $50.11.
  • Levered free cash flow at $3.45B vs. enterprise value at $32.65B (implies a LFCF/EV ratio at 10.57%). Even on a Price to Free Cash Flow basis the stock looks cheap, with a ratio of 1.6, compared to Unum Group (P/FCF ratio at 5.67) and Assurant Inc. (P/FCF ratio at 6.63).
  • Diluted TTM earnings per share at 6.11, and a MRQ book value per share value at 34.16, implies a Graham Number fair value = sqrt(22.5*6.11*34.16) = $68.53. Based on the stock's price at $49.49, this implies a potential upside of 38.47% from current levels.
  • Divided yield at 2.8%, and payout ratio at 22%.

2. Humana Inc. (NYSE:HUM): Offers various health and supplemental benefit plans in the United States.

  • Market cap at $12.51B, most recent closing price at $77.56.
  • Levered free cash flow at $905.38M vs. enterprise value at $6.23B (implies a LFCF/EV ratio at 14.53%). On a Price to Free Cash Flow basis the stock looks cheap, with a ratio of 8.94, compared to WellPoint Inc. (P/FCF ratio at 11.25) and Unitedhealth Group, Inc. (P/FCF ratio at 11.99).
  • Diluted TTM earnings per share at 7.47, and a MRQ book value per share value at 55.88, implies a Graham Number fair value = sqrt(22.5*7.47*55.88) = $96.91. Based on the stock's price at $78.27, this implies a potential upside of 23.82% from current levels.
  • Dividend yield at 1.3%, and payout ratio at 14%.

3. L-3 Communications Holdings Inc. (NYSE:LLL): Provides command, control, communications, intelligence, surveillance, and reconnaissance systems; aircraft modernization and maintenance; and government services in the United States and internationally.

  • Market cap at $7.51B, most recent closing price at $82.45.
  • Levered free cash flow at $2.35B vs. enterprise value at $10.71B (implies a LFCF/EV ratio at 21.94%).
  • Diluted TTM earnings per share at 8.3, and a MRQ book value per share value at 60.41, implies a Graham Number fair value = sqrt(22.5*8.3*60.41) = $106.21. Based on the stock's price at $82.4, this implies a potential upside of 28.9% from current levels.
  • Dividend yield at 2.7%, and payout ratio at 25%.

4. Northrop Grumman Corporation (NYSE:NOC): Provides products, services, and solutions in aerospace, electronics, information systems, shipbuilding, and technical service sectors.

  • Market cap at $17.18B, most recent closing price at $72.11.
  • Levered free cash flow at $2.07B vs. enterprise value at $16.93B (implies a LFCF/EV ratio at 12.23%).
  • Diluted TTM earnings per share at 7.81, and a MRQ book value per share value at 39.77, implies a Graham Number fair value = sqrt(22.5*7.81*39.77) = $83.60. Based on the stock's price at $71.56, this implies a potential upside of 16.82% from current levels.
  • Dividend yield at 3%, and payout ratio at 27%.

5. Principal Financial Group Inc. (NYSE:PFG): Provides retirement savings, investment, and insurance products and services worldwide.

  • Market cap at $10.4B, most recent closing price at $35.45.
  • Levered free cash flow at $1.79B vs. enterprise value at $7.78B (implies a LFCF/EV ratio at 23.01%). Principal Financial Group's Price to Free Cash Flow also makes the stock looks cheap, with a ratio of 3.63, compared to The Bank of New York Mellon Corporation (P/FCF ratio at 94.48) and Franklin Resources Inc. (P/FCF ratio at 129.28).
  • Diluted TTM earnings per share at 2.57, and a MRQ book value per share value at 33.2, implies a Graham Number fair value = sqrt(22.5*2.57*33.2) = $43.82. Based on the stock's price at $33.47, this implies a potential upside of 30.91% from current levels.
  • Dividend yield at 2.6%, and payout ratio at 30%.

6. Torchmark Corp. (NYSE:TMK): Provides individual life and supplemental health insurance products, and annuities to middle income households.

  • Market cap at $5.59B, most recent closing price at $59.62.
  • Levered free cash flow at $985.58M vs. enterprise value at $6.60B (implies a LFCF/EV ratio at 14.93%). The stock's Price / Free Cash Flow ratio stands at 6.16, much higher than Prudential plc (P/FCF ratio at 0) and ING Groep NV (P/FCF ratio at 0).
  • Diluted TTM earnings per share at 5.41, and a MRQ book value per share value at 46.29, implies a Graham Number fair value = sqrt(22.5*5.41*46.29) = $75.06. Based on the stock's price at $58.14, this implies a potential upside of 29.11% from current levels.
  • Dividend yield at 1.2%, and payout ratio at 11%.

*EPS and BVPS data sourced from Yahoo Finance, all other data sourced from Finviz.

Source: 6 S&P 500 Dividend Stocks Undervalued By Free Cash Flow And The Graham Number