Looking for Sustainable Dividends

Dividend stocks are most useful when utilized as a source of stable income, preferably when the dividend payout can be counted on to grow over the years. There are several Magic Formula stocks with dividend yields that can be considered high (over 3%). But how can we determine if the yield is sustainable and likely to go up in the future?

One common way to measure the sustainability of a dividend is through the payout ratio. For most financial sites, this is the amount paid out in dividends divided by net income over the past 12 months. But this is not really the best way to do it. Since the cash flow statement tells us directly how much cash was produced by the business ("cash from operations"), we don't need to guess! Also, we need to subtract capital expenditures needed to maintain the business: The result is known as free cash flow. This is the best figure to use when calculating dividend payout ratio, instead of net income.

Source: The Street

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