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We use dual cash flow analysis as a primary screen for vetting investment candidates being considered in our portfolios. Although we have tweaked our model over the years to include more complex accounting analysis of the financial statements, the nuts and bolts of our screen focus on the sources of cash flow and their contributions to earnings.

Our research has shown that companies and businesses who generate most of their cash flow from “operations” tend to have higher quality-of-earnings than companies who rely on non-cash balance sheet "maneuvers" to support earnings.

Understanding the components of an earnings report gives us a good picture of a company’s financial health and liquidity. Studying the changes within these relationships over multiple periods (quarterly or annually) allows us to identify potential opportunities and detect possible danger looming ahead. The dual cash flow technique has also shown to be a very effective tool for evaluating dividend safety/risk. As in earnings quality, the premise for dividend quality is similar.

Stable and/or growing cash-flows generated by operating activities (i.e. paying customers) are more likely to support a current dividend and open the door for future dividend hikes going forward. In contrast, companies who support their dividend with debt or non-operating cash may find themselves in a position to cut, suspend or eliminate their distributions.

There are many strategies for evaluating dividends. Some methods use discounted cash-flows, or net cash on the balance sheet along with estimates of “future” free cash-flow forecasts. Problem is, predicting future cash-flows can be compromised by input variables, cost of capital, etc.

Using past results is not perfect either, but at least we can see the trends developing by observing how a business manages its liquidity. Consistency of earnings quality matters a lot to dividend growth and sustainability.

In this market environment, utilities, pharmaceuticals and consumer staples have been popular defensive plays, given their history of strong cash flow generation, dividend stability and perceived insulation from economic cycles. Utilities, being rate-sensitive and capital-intensive, have benefitted from a protracted low interest rate environment. Yet, eventually, their borrowing costs are likely going to rise faster than earnings growth.

Pharmaceuticals, particularly major drug manufacturers look interesting as the quest for finding cures to prolong the lifespan of our species will always be sought. Too often, we hear about patent expirations and generic cannibalism, yet somebody has to develop the products which address our corporal needs. Names such as Pfizer (NYSE:PFE), Bristol Meyers (NYSE:BMY) and Merck (NYSE:MRK) come to mind.

Consumer staple and services companies are also known for generating healthy amounts of cash flows. Just look around your home and you will see why. There is food in the kitchen, toilet paper/toothpaste/shampoo in the bathroom, laundry detergent/cleaning supplies in the utility room, light bulbs in every room, etc., etc. etc. Then, when you’re done using all this stuff, it goes in the recycle bin or trash can.

In the sections below, we have listed a hand-full of companies fitting the profile for sustainable dividends, potential increased dividends, and a few that might be vulnerable.

Sustainable Dividends: These stocks have recent DCF ratios that are consistent with (similar to) their average DCF ratio during the previous year.

Waste Management (NYSE:WM): The business of collecting, transporting and processing garbage is very capital intensive. We like WM for its asset base and progress in waste-to-energy endeavors. Our dual cash flow indicator indicates that while WM operates in a leveraged financial structure, operational cash flow contributions to earnings remain consistent and stable. Current yield: 4.30%.

ConAgra Foods (NYSE:CAG): We have followed this packaged food company for a long time and owned the shares at various times over the years. While the stock appears fully valued at current levels, it was music to our ears that the Ralcorp (NYSE:RAH) deal did not happen.

Had the deal occurred, CAG would have likely faced a downgrade to its credit rating, not to mention the risk of a dividend cut. Yet, management has done a good job in shedding non-core businesses and trimmed debt. Absent an un-digestible acquisition by CAG in the near future, the company’s operational cash-flows should provide a cushion to maintain the current distribution rate. Current yield: 3.80%.

Pfizer (PFE): Despite the loss of Lipitor patent exclusivity and political finger pointing by the likes of Sen. Max Baucus (D-MT) regarding the company’s marketing tactics, Pfizer has promising oncology drugs in the pipeline and potential opportunities in biologics (from the acquisition of Wyeth). Debt is less than half of equity, and cash is about $29 billion; a solid balance sheet. Current yield: 4.00%

Possible Dividend Increases: These stocks display recent period DCF ratios which are greater than the average DCF ratio during the prior year.

Johnson & Johnson (NYSE:JNJ): JNJ makes everything from band-aids to medical devices. With 250 operating units, we’re not surprised to see a flurry of product recalls and a languishing stock price. However, dual-cash trends have been trending “bullish” and the company is sitting on about $11 a share in cash and equivalents. If the company can get a handle on the product issues, it would not take much in the way of revenue or earnings growth to step-up the distribution. Current yield: 3.60%.

Intel (NASDAQ:INTC): There are a handful of semiconductor stocks paying dividends these days, but INTC stands out with its rock solid balance sheet, buttressed with $15 billion in cash.

The real attraction however, is that management has done a great job improving its capital productivity (especially with income producing assets such as property, plant & equipment).

Given the flexibility in their capacity and adept management of inventory, any pick-up in demand would be a catalyst for earnings growth and a bump in the stipend to shareholders. Current yield: 3.30%.

Possible Dividends at Risk: These stocks display recent DCF ratios which have either declined precipitously and/or are less than the average DCF ratio during the prior year.

Cooper Tire & Rubber (NYSE:CTB): We have followed this maker of replacement tires for many years and have owned the shares at various times. We were bullish on the stock last March when earnings yields were more than 9%.

While management has been very proactive at lowering labor unit costs, rising input costs (raw materials) have put the whammy on earnings and cash-flow since. Our dual cash-flow indicators reveal a contraction in the DCF ratio from the highs set in March 2011 and a decline in the earnings yield back to levels seen in Dec 2009.

The underlying stock looks inexpensive when compared to “enterprise” value, and we believe this metric might hold some appeal as a potential LBO takeover target somewhere down the road. However, cash declines, coupled with the aforementioned slip in DCF ratio suggest an elevated risk of a possible dividend cut in the not too distant future. Current yield: 3.10%.

Verizon (NYSE:VZ): While some would argue that Verizon’s dividend is safe, we would argue that investors might better maximize total returns by waiting for a pullback in the stock (to buy) rather than focus on the dividend. Why?

VZ’s new spectrum deal signals a new direction for the company’s future growth. Unfortunately, it comes with a hefty $3.6 billion price tag. Adding spectrum for wireless customers makes perfect sense. But, we’re not talking chump change here and $3 + billion will impact their capital structure.

VZ has always been keen on maintaining a robust network and their history of CAPEX shows this commitment. If investors were to embrace the future profit potential of spectrum, perhaps they might not be too put out by a nick in the distribution. Payout ratio is presently 94% of sales. Current yield: 5.20%.

Summary: These companies by no means reflect the entire dividend universe, but investors can use them as a starting point in their search for yield growth and safety.

Sources: Yahoo Finance, SA, Reuters, merriamreport.com To learn more about dual cash flow, visit merriamreport.com.

Source: Using Cash Flow To Evaluate Dividend Safety