Fred Alger Management in its research report on companies with high free cash flow yields concludes that "Companies with the highest free cash flow yields…have historically outperformed other companies with lower free cash flow yields."
According to statistics from Empirical Research Partners used in the above-noted report, "For the 50-year period (through May 31, 2011), the annualized return of high cash flow companies was 17.7%, while the (broader market) generated a return of 11.1%."
The broader market in the study consisted of the largest 750 stocks by market capitalization plus the S&P500 constituents not already included in the group. Hence, empirical evidence showed that companies with high free cash flow yields generated a 6.6% excess return per year relative to the broader market.
Some analysts prefer free cash flow yield to earnings yield or P-E ratio as a valuation tool because it seems to be a more accurate indicator of investment return. Here is a quick glance at five dividend stocks with rich free cash flow yields above the average yields for their respective industries. The overview includes companies of varying market capitalization and dividend yields on par or above 2%. All companies appear undervalued based on the market and industry comparisons of P-E ratios and free cash flow yields.
L-3 Communications Holding (LLL) is an aerospace and defense products and services companies with customers in the defense, homeland security, aerospace, intelligence, and telecommunications industries. The company generated some $1.3 billion or $12.2 a share in free cash flow in 2011. It currently appears undervalued, given that it boasts a high free cash flow yield of 15.7% that is well above its industry's average free cash flow yield of 9.2%. The company boosted its free cash flow more than five times over the past decade.
Currently, L-3 Communications pays a dividend yield of 3.0% on a payout ratio of 22%. Its peers Honeywell International (HON), Lockheed Martin (LMT), and Raytheon Company (RTN) pay dividend yields of 2.8%, 4.9%, and 4.0%, respectively. While the company is expected to see a modest growth in earnings per share (EPS) due to defense budget austerity, its capacity to generate large annual free cash flows remains intact. Guru fund manager Joel Greenblatt increased his small position in the company in the first quarter of 2012.
Xerox Corp. (XRX) is a multinational document management and related services company. It has been a consistent generator of large positive free cash flows for years. Last year, the company earned about $1.5 billion or $1.1 a share in free cash flow. Currently, its stock has a 12.5% free cash flow yield, which is more than six times the average yield for its industry.
Analysts forecast robust EPS growth of nearly 12% a year over the next five years. Given that the company has stable annuity-like revenue flows, the increase in EPS is likely to translate into large free cash flows. Xerox Corp. pays a dividend yield of 2.4% on a payout ratio of 19%. Its peers Cannon (CAJ), Hewlett-Packard (HPQ), and Lexmark International (LXK), are yielding 3.8%, 2.4%, and 4.8%, respectively.
Among fund managers, David Einhorn's Greenlight Capital reported owning 15.4 million shares in the company in the first quarter of 2012 (see Greenlight Capital's top picks). Hedge fund manager Larry Robbins is another major investor in Xerox.
Marvel Technology Group (MRVL) is a leading fabless semiconductor company with operations in 17 countries, including the United States. The company generated some $670 million or $1.1 a share in free cash flow last year. Currently, it is undervalued relative to its peers as Marvel Technology's free cash flow yield stands at 10.2%, well above the industry's yield of 6.9%.
Analysts expect the company to grow its EPS robustly, by nearly 15% a year over the next five years, which should help sustain free cash flow generation after accounting for capital expenditures. The chipmaker currently has dividend yield of 2.0%, some 70 basis points less than its peers on average. Rivals STMicroelectronics N.V. (STM) and Broadcom (BRCM) pay dividend yields of 6.9% and 1.3%, respectively. LSI Corporation (LSI) does not pay any dividends. Marvel Technology has a dividend payout ratio of 26%.
Billionaire David Einhorn has a 3.14% stake in the company. David Tepper acquired a new stake in the company in the first quarter of 2012.
Cisco Systems (CSCO) is a network equipment giant selling network routers, switches, and related products and services. The company has been a free cash flow machine. It generated $8.9 billion or $1.6 a share in free cash flow in 2011. Cisco Systems' stock is somewhat undervalued compared to its industry given that it boasts a free cash flow yield of 10.1%, above the industry's average yield of 8.6%.
The company is expected to grow its EPS 10% a year for the next five years. However, that rate could moderate given that the company's sales have weakened notably in Europe. Still, as Cisco Systems has been able to maintain its free cash flow above $1.1 billion each year since 2007, even during the 2008 global financial and economic crisis, the company is unlikely to see a major reduction in the free cash flow level in the coming year.
The network giant pays a dividend yield of 2% on a low payout ratio of 24%. Its peer Hewlett-Packard pays a dividend yield of 2.4%, while competitors Alcatel-Lucent (ALU) and Juniper Networks (JNPR) do not pay any dividends. Guru fund managers Jean-Marie Eveillard, Donald Yacktman, and Andreas Halvorsen are major investors in the company.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.