Should You Look At Free Cash Flows To Find Safer Dividend Payers?

Summary

• In December I wrote an article for Master Investor magazine talking about my stock market tip for 2019.
• After some additional thought and meditation I have decided to back-track somewhat on my short-lived enthusiasm for free cash flows.
• Tesco is a prime example of what can happen when dividends are repeatedly paid with debt rather than free cash flow.

In December I wrote an article for Master Investor magazine talking about ‘my stock market tip for 2019’.

At the time I was looking to switch my investment strategy from an earnings-based approach to one centred around free cash flows (i.e. operating cash flow minus capital expenses).

However, after some additional thought and meditation I have decided to back-track somewhat on my short-lived enthusiasm for free cash flows.

Instead of using free cash flows to find safer dividends, I’m going to focus on reported earnings, growth of capital employed, net profit margins and the avoidance of turnaround situations.

This doesn’t mean I think free cash flows are a useless metric, because I don’t. I still think free cash flows are worth looking at in some situations, such as a capital intensive company undergoing rapid growth.

It’s just that in most cases, when you focus on companies with high returns on sales (net margins), high returns on capital, low debts and healthy dividend cover, the company also has good free cash flows which more than cover the dividend over time.

So despite not using free cash flows as a core metric anymore, I’ve decided to re-post the article here because:

a) I think it contains some interesting/useful info and

b) it takes a minor dig at Tesco because that company is a prime example of what can happen when dividends are repeatedly paid with debt rather than free cash flow: