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In my last article, I discussed the importance of the payout ratio when it comes to picking healthy dividend-paying stocks. The payout ratio is the percentage of net income that is paid out in dividends.

In response, I received some comments suggesting that free cash flow and levered free cash flow are more accurate measurements of testing whether a company can continue to pay its dividend.

Let’s deal with both – and then look at three companies that are in solid shape from a cash flow perspective…

Cash Flow vs. Income: Who Wins?

The payout ratio is a key metric when you’re evaluating a company’s ability to pay its dividend. But readers who left comments in favor of cash flow are also absolutely right.

Cash flow is much harder to manipulate, as it measures the amount of cash coming into a business, versus the cash that heads out the door.

Levered free cash flow also takes into account the interest and principal payments on borrowed funds. It’s the truest gauge of how much cash the company actually generates.

And this is important because executives can fudge net income to say almost anything they want. Remember Enron?

So if you’re depending on the income that dividend-yielding investments produce, the reliability of the dividend is critical.

That’s why we don’t chase yield. We’re more interested in the stability and growth of dividends. After all, what good is a 9% yield if it gets cut? It’s more valuable to have a reliable company that increases its dividend year after year.

In my last column, I screened for stocks whose dividends may be in jeopardy based on the payout ratio. Today, we’re hitting the cash road…

Secure Dividends Based on Levered Free Cash Flow

Here are three companies whose dividends not only appear secure, but also have plenty of room for growth, based on levered free cash flow…

  • Meredith Corp. (NYSE: MDP): The publisher of Better Homes & Gardens, Ladies Home Journal and other magazines generated $144.4 million in levered free cash flow over the past 12 months. During that period, it paid out nearly $42 million in dividends. Meredith has increased its dividend every year since 1996 and with cash flow over three times more than its dividend payment, it has plenty of room to increase the dividend past the current 2.9% yield.
  • Northrop Grumman (NYSE: NOC): Even with budget-slashing politicians taking an axe to anything they can get their hands on, this massive defense contractor should be just fine. Profits are still projected to grow at a double-digit annual rate over the next five years. The company has already paid $545 million in dividends and with $1.6 billion in levered free cash flow pouring in, Northrop should have no problem increasing its dividend for the seventh straight year, beyond the current 2.8% yield.
  • V.F. Corp. (NYSE: VFC): The maker of Wrangler, Lee and North Face clothing brands is also expected to notch double-digit earnings growth over the next five years. That should add to the $916.5 million in levered free cash flow over the past 12 months. During that time, VFC has paid out $264 million in dividends. With an impressive 25-year track record of annual dividend increases, the streak should continue, making investors currently earning a 2.6% yield quite happy.

Cash Is King

Just like in your own life, cash is king.

It doesn’t matter what your paycheck says if, after paying taxes, interest and principal on your loans, you don’t have anything left for things like vacations, new appliances for your home, or your kids’ allowance.

As you know, the cash that’s left over after you’ve paid all the bills is the real indicator of financial health.

It’s the same principle with a company. A payout ratio based on net income is a good place to start. But to be certain that your dividend is secure, dig down into metrics like levered free cash flow for a clearer picture.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.

Source: Why Levered Cash Flow Is Crucial for Picking Reliable Dividend Stocks