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Wed. Jun. 10, 2009

Five Stocks With A Low Dividend Payout Ratio *

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.

(Photo: Steve Woods)

9 Responses to “Five Stocks With A Low Dividend Payout Ratio *”

  1. Interesting post. I am a firm believer in using earnings, since they could be turned into cash some time down the road. I think that using cash only without looking at EPS could present a challenge.
    For example if a company that had not expenses sold advertising for 5 years at 5 million dollars, earnings would be one million/year for 5 years. Cash flow however would be 5 million in the first year and 0/year for the next 4 years.
    See what I mean? If the dividend was $500K/year, the first year the Dividend payout would be 10% with the cash method, and off the charts over the next 4 years.
    With earnings however, the payout would have been 50% for 5 years.
    See what I mean?

  2. DFL, what is your reasoning for holding so many stocks?

    Seems to me, if one is focused on great companies, which have products or services in demand all the time, with great dividend credentials and some good growth credentials, heck, just pick maybe 10 or so, and be in a better position to watch and manage each stock(like periodically adding or subtracting as situations present themselves), hence easier managing of the whole portfolio.

    Basically, my approach is to look for such a company as one which I would like to own completely, if I could, for the long term. Then, add only a few more, thinking of myself as a businessman, not really as a stock player, per se. It’s basically an attitude.

  3. DFL, why do you hold so may stocks?

  4. @DGI: Dividends are paid with cash. If the company squanders the cash in year 1, money won’t be avilable in years 2-5 to pay dividends. Accrual accounting has too many oddities to use GAAP EPS todetermine the ability to pay dividends.

    @Joseph: Diversification. I don’t want any individual stock to be more than 5% of my holdings on either a market value or income basis.

    Best Wishes,
    D4L

  5. Hahnderosa says:

    I like this approach EXACTLY because of accounting tricks as you allude to with DGI. I have eliminated several dividend potentials form my list as a result. Love AFLAC and wonder if MO is a good short term place to park some cash (from a business standpoint, ethics aside).

    Disc: AFL long

  6. Hahnderosa: Thanks for stopping by and commenting!

    Best Wishes,
    D4L

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