Monday February 06, 2012
by Carla Pasternak, editor High-Yield Investing
The best tool I have found to determine what a company really has left after expenses for shareholder dividends is a little known metric called free cash flow to equity (FCFE).
FCFE strips out all capital expenditures and adds back net borrowings that can be used to pay dividends. Using FCFE in the denominator of the payout ratio instead of more traditional earnings measures can help separate the safer dividend plays from the more aggressive ones.
Companies aren't required to give this measure in their earnings reports, and most don't. You can get a rough estimate from a free financial website such as Yahoo! Finance. "Levered free cash flow" on Yahoo's Key Statistics page is similar to free cash flow to equity.
However, their formula uses earnings before taxes instead of operating cash flow and assumes a corporate tax rate of 37.5%, which may not apply. So, you may need to calculate the numbers yourself.
But don't worry. That's what I'm here for.
In my search for dividends that are well covered by existing FCFE, without an immediate need to be bolstered with more debt or equity capital, I was surprised. I found dozens of stocks with yields of 5%-plus that also had FCFE payout ratios of around 50% or lower over the past year.
So, I added a performance criterion, reasoning that out-performing stocks are poised to lead the charge should the market rebound in the year ahead.
Below are the five stocks I found with the highest dividend yield and lowest FCFE payout ratio that also outperformed the S&P over the past year:
After meeting its obligations, management could decide to buy back shares with the free cash flow instead, or have some other use for the money.
Also, FCFE can vary greatly from year to year, so the payout ratio can also vary greatly. Still, well-managed companies with sustainable dividends tend to maintain a steady stream of FCFE over the long-term.
And if you're simply looking for a secure dividend payment, the list above is a good place to start.
Learn more about this financial newsletter at Carla Pasternak's High-Yield Investing.