In my previous article, I talked about the regular payout ratio investors should consider looking at before investing in a dividend paying stock. I would like to dig even deeper into what to look for when analyzing an investment. I want to bring up the free cash flow payout ratio.
Many of you know what free cash flow is, but for those who don't, here is an example. Let's say you make $100,000 a year and have a car valued at $30,000. Now a car depreciates in value because it has a limited lifetime. Let's say the car depreciates in value by $10,000 each year. So basically you are losing $10,000 each year, right? Not really, your car still works fine and it will probably continue to work fine for a long time. However, the way publicly traded companies do their income statements, they actually would count the $10,000 as a loss. So they would see you making $90,000 a year instead of the $100,000, even though you technically didn't lose money.
Many companies have a lot of depreciating assets. Oil companies have rigs that lose value over time. Transportation companies have ships and trucks. So it is important to know that when analyzing these statements, you should read the cash flow statements.
I want to explain how it should be used in dividend investing. Many income investors may just look at a company's earnings and see how much is being paid out in dividends. Instead they should be observing how much of the free cash flow is being paid out. This is actually very easy to look up.
Free Cash Flow = Operating Cash Flow - Capex
Let's use a few examples. Frontier Communications (FTR) is a company thats pays a 10.5% dividend. The payout ratio shows as over 400%. However if you dig deeper, then you see a different story.
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The company is getting a very large amount of free cash flow and is easily able to cover the dividend payments. This is very similar to CenturyLink (CTL), which is in the same business as Frontier. CenturyLink pays a 8.4% dividend and has a payout ratio of 123%, but in reality its dividend payment is about 75% of free cash flow.
Take a look at Hospitality Properties Trust (HPT). It pays a 7.8% dividend and has a payout ratio of over 600%. However, if you look through its cash flows, you can see that they are able to cover the payments. Hotels tend to depreciate in value fast and need costant upkeep, so it's no wonder the company's net is reported the way it is.
Free cash flow should always be used when analyzing dividend paying stocks. There are strong companies out there that can easily cover their high yields, but due to accounting procedures, many investors look at net income and turn away. I hope all you income investors out there start using this simple but effective strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.