Are you looking for companies that can sustain and grow their dividend? In making that determination, a company's Statement of Earnings is one of the last places you should look. Cash is king for the dividend investor and the Statement of Cash Flows is where astute investors begin when they want to understand the viability of a company.
It's not that most companies have done anything wrong when preparing their Statement of Earnings, but under Generally Accepted Accounting Principles (GAAP) a lot of the entries have nothing to do with today's operations. Given this, I generally avoid most earnings related metrics (e.g. EBIT, EBITDA, payout ratio, etc.)
The cash flow statement is not based on accrual accounting, but instead is a cash-basis report focusing on inflows and outflows of cash. It adjusts for transactions that do not directly affect cash receipts and payments, such as adding depreciation back to net earnings. The cash flow statement allows investors to understand how a company's operations are running, where the cash is coming from and how it is being spent.
As an investor in dividend growth stocks, I want to know if a company is financially capable of paying me a higher dividend each year. That's why I focus on cash-based metrics such as these:
Free Cash Flow This has many definitions, but the one I use is operating cash flow less capital expenditures. Capital expenditures are deducted since you can't run a business for any period of time without expending some level of capital. These two numbers are easily located on the Statement of Cash Flows. This is the best snapshot of what cash the business has generated from "normal" operations and is available for dividends, debt, acquisitions and purchases of treasury stock.
Cash Flow Per Diluted Share GAAP Earnings Per Share (EPS) has the same short-comings as GAAP earnings. When looking at per numbers I prefer a cash-based number. Cash Flow Per Diluted Share is calculated by taking the Free Cash Flow from above and dividing it by diluted shares outstanding (available on the Statement of Earnings).
Cash Payout Ratio Dividend investors love payout ratios (dividends per share divided by EPS). Given my concerns with GAAP earnings and EPS, I once again prefer a cash-based version. The Cash Payout Ratio is calculated by dividing dividends per share by Cash Flow Per Diluted Share. Care should be taken when interpreting this ratio. For example, sometimes a high ratio with low debt is better than a low ratio with high debt.
Cash Return on Capital Employed This is simply Free Cash Flow divided by Total Capital (debt + equity). Again, I prefer using a cash number in the numerator. A lot of investors look at return on assets and return on equity. Each are flawed beyond their GAAP numerator. Return on assets ignores the liabilities side of the balance sheet, while return on equity ignores the debt component of capital.
You can fake earnings, but you can't fake cash.
This week, I screened my dividend growth stocks database for select non-financial dividend stocks that have a free cash flow payout of 50% or less with a yield of 3.0% or more. The results are presented below:
Sonoco Products Co. (NYSE:SON) makes of paper and plastic packaging products serves various industries and markets in more than 85 countries.
Yield: 3.2% | FCF Payout: 43.09%
Meredith Corp. (NYSE:MDP) publishes a suite of magazines and websites focused on food, parents and women (Better Homes and Gardens) and operates 12 local TV stations.
Yield: 3.4% | FCF Payout: 43.64%
Yield: 3.5% | FCF Payout: 46.37%
Yield: 4.2% | FCF Payout: 46.21%
AT&T Inc. (NYSE:T) provides telephone and broadband service and holds full ownership of AT&T Mobility (formerly Cingular Wireless).
Yield: 5.2% | FCF Payout: 49.31%
As with past screens, the data presented above is in its raw form. Some of the the companies would be disqualified for poor business fundamentals. However some of the others may be worth additional due diligence.
Disclosure: Long T in my Dividend Growth Portfolio and long MDP, VZ in my High-Yield Portfolio. No position in the aforementioned securities. See a list of all my dividend growth holdings here.