Look For Stocks That Can Cover Their Dividend

As we discussed last week, when selecting a dividend growth stock there is really only one factor that is important – sustainability. As dividend growth investors we are looking for stocks can continue to raise their dividends indefinitely into the future. One metric that provides an indication of a dividend's sustainability is its payout ratio.

The traditional dividend payout is expressed as a percentage and is calculated by dividing annual dividend per share by annual earnings per share (EPS). This tells the investor what percentage of earning the company is paying out as a dividend. At first blush this may seem to make a lot of sense, but it suffers from two potential problems in that 1.) earnings does not always equal cash and 2.) there is no indication of the quality of earnings.

I consider Free Cash Flow payout a better ratio. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section of the GAAP cash flow statement). The formula for Free Cash Flow Payout is simply Annual Dividend Per Share divided by Free Cash Flow Per Share. I like to see a percentage of 70% or less.

Taking a look at my stock database, I found the following eight dividend stocks with a free cash flow of 50% or less and rated 4 or 5 stars:

• Procter & Gamble Co. (PG) - 4-Star [Analysis]
  - FCF Payout: 42%
  - Yield: 2.90%


• Emerson Electric Co. (EMR) - 4-Star [Analysis]
  - FCF Payout: 42%
  - Yield: 3.10%


• Abbott Labs (ABT) - 4-Star [Analysis]
  - FCF Payout: 42%
  - Yield: 2.96%


• Johnson & Johnson (JNJ) - 4-Star [Analysis]
  - FCF Payout: 38%
  - Yield: 3.00%


• Harleysville Group Inc (HGIC) - 4-Star [Analysis]
  - FCF Payout: 37%
  - Yield: 3.93%


• Nucor Corp (NUE) - 4-Star [Analysis]
  - FCF Payout: 27%
  - Yield: 3.00%


• Becton Dickinson & Co. (BDX) - 5-Star [Analysis]
  - FCF Payout: 32%
  - Yield: 1.88%


• United Technologies Corp (UTX) - 5-Star [Analysis]
  - FCF Payout: 29%
  - Yield: 2.22%

The ability of a stock to sustain its dividend separates dividend growth stocks from stocks that simply pay a dividend. The latter is quite common, while the former helps define The Best Dividend Stocks in the World.

Although Free Cash Flow Payout is a better payout ratio than the traditional dividend ratio, the investor should look at both and understand the differences. Taking an expense for impairing goodwill is much different than recognizing an expense for losing a lawsuit. The former will not directly involve cash out the door, but the latter will if the company loses on appeal.

Full Disclosure: Long PG, EMR, ABT, JNJ, NUE, UTX. See a list of all my income holdings here.

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