The main focus of dividend investing is finding and buying dividend stocks that will likely continue to raise their dividends in the future. In making this determination there are many factors to consider. One of the more important metrics to consider is the Dividend Payout Ratio.
Traditionally, this is calculated as Annual Dividend Per Share divided by Earnings Per Share (EPS). I don’t particularly care for this calculation. Due to all the odd accounting rules EPS is not cash. Instead, I prefer to use a Free Cash Flow Payout Ratio.
Free Cash Flow has several different definitions, but the one I use is Operating Cash Flow less Capital Expenditures. Both of these amounts are found on the statement of cash flows. Operating cash flow starts with Net Earnings and adjusts out non-cash items, such as depreciation and amortization, and non-operating items such as land sales.
Since a business can’t continue in the long-term without capital spending (machinery and equipment, etc.), capital expenditures are subtracted from operating cash flow in calculating free cash flow. It is important to note, that only “normal” capital expenditures are deducted, not acquisitions. The decision to make an acquisition is strategic, not operating.
Once calculated, Free Cash Flow is divided by diluted shares to put it on a per share basis. Finally, the annual dividend per share is divided by free cash flow per share to calculate the payout ratio. With the traditional EPS based payout ratio, many people consider 50% or below good. However, since a lot of the noise has been removed when using free cash flow, I consider a payout ratio of 60% or lower good.
The lower the payout ratio the more cash is available to increase the company’s dividend. A low ratio is especially good during an economic downturn, when the amount of cash generated will likely be less.
Here are five stocks with a free cash flow payout ratio less than 30%:
1. AFLAC Inc (AFL)
Payout Ratio: 10.8% – Yield: 3.30% – Analysis
2. Nucor Corp (NUE)
Payout Ratio: 29.0% – Yield: 2.90% – Analysis
3. United Technologies Corp. (UTX)
Payout Ratio: 29.8% – Yield: 2.70% – Analysis
4. Lowe’s Companies Inc. (LOW)
Payout Ratio: 23.4% – Yield: 1.80% – Analysis
5. Brady Corp. (BRC)
Payout Ratio: 26.8% – Yield: 2.70% – Analysis
I am currently reworking my dividend analysis worksheets to focus on what’s most important in selecting a dividend stock. A Free Cash Flow dividend payout of less than 60%, will earn the company a star.
Full Disclosure: Long AFL, NUE, UTX. See a list of all my income holdings here.