All income investors love a stock with a good yield. The smart ones look for dividends that are sustainable and likely to grow. The question is, 'In an uncertain world, how do you determine which dividends are sustainable and likely to grow?'
Of coarse, there is no way to know with exact certainty which dividends are sustainable, but there are tell-tale signs that often foretell the future. Let's look at a couple of them.
Free Cash Flow Payout
A dividend payout ratio is supposed to provide the investor with an indication of how much cash as a percent of earnings the company is paying its investors. A payout ratio based on GAAP net earnings could potentially have a lot of noise in it and not provide a clear picture of the economic condition of the business. Dividends are paid with cash, not Net Earning, EPS, EBIT, EBITDA or any other metric Wall Street analysts like to look at.
In calculating a payout ratio, I prefer Free Cash Flow over the traditional payout ratio based on GAAP earnings. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section). For a business to remain viable it must replace capital assets when they wear out. The formula for Free Cash Flow Payout is simply Annual Dividend Per Share divided by Free Cash Flow Per Share. The lower the ratio, the better.
Debt To Total Capital
To pay and raise its dividend a company must generate sufficient free cash flow. However, it is not enough to just generate the cash, it has to be available for dividend payments. Many companies generate significant free cash flow, but often that cash is already spoken for in the form of debt obligations.
To gauge how levered a company is, the metric I like to look at is debt to total capital. Debt includes both long-term and short-term debt and is readily available on the liabilities side of the balance sheet. Total capital is a combination of debt and shareholders equity. When you divide debt by total capital a desirable rate is something less than 35%, but I will consider rates up to 50% on a short-term basis.
This week week, I screened my dividend growth stocks
database for stocks with debt to total capital less than 30%, a free cash flow payout less than 50% and a dividend yield above 3%.