Here are several companies sharing their holiday spirit by giving their shareholders a gift of increased dividends through increased cash distributions:

AT&T (T) provides telephone and broadband service. December 18th the company increased its quarterly dividend 2.4% to $0.42/share. The dividend is payable February 1, 2010, to common stockholders of record on January 8, 2010. The ex-dividend date is January 6, 2010. T is a Dividend Achiever and has raised its dividend for 26 consecutive years. The yield based on the new payout is 6.02%.

Franklin Resources (BEN) is one of the world’s largest asset managers, serving retail, institutional, and high-net-worth clients. December 18th the company raised its quarterly dividend $0.22/share and announced a special dividend of $3.00/share. The quarterly dividend is payable on January 8, 2010 to stockholders of record at the close of business on December 31, 2009. The special dividend is payable on December 31, 2009 to stockholders of record at the close of business on December 28, 2009. BEN is a Dividend Achiever and has raised its dividend for 29 consecutive years. The yield based on the new payout is 0.82%.

Ensign Group (ENSG) provides skilled nursing and rehabilitative care services in California, Arizona, Texas, Washington, Utah and Idaho. December 21st the company boosted its quarterly dividend to $0.05/share. The dividend, is payable on or before January 31, 2010 to shareholders of record as of December 31, 2009. The ex-dividend date is December 29, 2009. The yield based on the new payout is 1.32%.

Bristol-Myers Squibb (BMY) is a leading global drugmaker, with strengths in cardiovascular, anti-infective and anticancer therapeutics. December 21st the company increased its quarterly dividend 3% to $0.32/share. beginning in the first quarter of 2010. James M. Cornelius, chairman and chief executive officer of Bristol-Myers Squibb said in a statement:

This dividend increase reflects our ongoing commitment to deliver shareholder value. We have made excellent progress in executing our strategy and we are confident in the strength of our BioPharma business. Our performance has helped put us in a strong cash position today and we expect solid cash flows to continue in the years ahead.

The next quarterly dividend will be payable on February 1, 2010 to stockholders of record at the close of business on January 4, 2010. The yield based on the new payout is 5.00%.

The First of Long Island (FLIC) provides financial services through its wholly-owned subsidiary, The First National Bank of Long Island. December 22nd the company raised its quarterly dividend to $0.20/share, for a total of $0.76/share declared representing a 15% increase over the $0.66/share declared in 2008. The dividend will be paid on January 8, 2010 to shareholders of record on December 31, 2009. The yield based on the new payout is 3.51%.

Dividend income is great, but a rising dividend income is something special! For a list of stocks with a long string of consecutive cash dividend increases, see this list.

Full Disclosure: No position in the aforementioned securities. See a list of all my income holdings here.

(Photo Credit)

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 the following potential problems:

I. Earnings Does Not Equal Cash

As an accountant, I can tell you our profession in its pursuit of theoretical perfection has adulterated the financial statements to the point that it has become very difficult for non-accountants to understand what’s behind the numbers.  Accounting pronouncements such as SFAS No. 143 “Accounting for Asset Retirement Obligations” (ARO) that requires a company to recognize expenses today for cash payments that may not occur for decades or even centuries widens the gap between earnings and cash. Applying “fair value” principles allowed under GAAP, financial institutions (and others) can mark to market debt on their books and create non-cash income or expense, depending on the direction of interest rates. Many point to mark to market accounting as one of the major contributors to the 2008 financial melt-down.

II. Quality of Earnings

Would you rather a company that you are invested in to increase its earnings by 1.) increasing sales and holding cost down or 2.) sell a fully depreciated plant. Obviously, you would rather have the former since it has the possibility of being duplicated over and over again. You can only sell a specific asset once. In addition to cash and non-cash earnings, a statement of earnings also contains operating and non-operating earnings.

A Better Dividend Payout Calculation

A dividend payout ratio is supposed to provide the investor with an indication of how much cash as a percent of earnings the company is paying its investors. As you can see from the above discussion, a payout ratio based on GAAP net earnings could potentially have a lot of noise in it and not provide a clear picture of the economic condition of the business.

What the investor is really wanting to know is what percentage of cash is the company paying as a percentage of cash generated from running the business. The irony here is that operating cash is readily available on the Statement Of Cash Flows in the Operating section. This section focuses on the cash generated by running the business. It excludes cash generated by selling pieces of the business – these are shown in the investing section. It also excludes cash generated from selling stock or issuing debt – these are shown in the financing section.

In calculating a payout ratio, I prefer Free Cash Flow over Operating Cash Flow. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section). For a business to remain viable, it must replace capital assets when they wear out.

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. The 70% is somewhat higher than many people look for with a traditional payout ratio. I am comfortable with the higher number since we are talking about real cash generated from running the business vs. accounting earnings that may or may not be there. So how do the two ratios compare?

Needless to say, the variances are all over the place. In many companies I looked at the traditional dividend payout ratio was within 10 percentage points higher than a free cash flow payout. This means the GAAP earnings was lower than the calculated Free Cash Flow. Here are some example of this situation:

• Chubb Corp (CB) – Traditional: 28% – FCF Payout: 21% – Analysis
• Clorox Company (CLX) – Traditional: 50% – FCF Payout: 50%
• Emerson Electric Co. (EMR) – Traditional: 53% – FCF Payout: 45% – Analysis
• Family Dollar Stores Inc. (FDO) – Traditional: 25% – FCF Payout: 22%
• Hormel Foods Corp. (HRL) – Traditional: 34% – FCF Payout: 33%
• International Business Machines (IBM) – Traditional: 23% – FCF Payout: 18%
• 3M Co. (MMM) – Traditional: 50% – FCF Payout: 45% – Analysis
• Microsoft Corp. (MSFT) – Traditional: 32% – FCF Payout: 29%
• SYSCO Corporation (SYY) – Traditional: 52% – FCF Payout: 48% – Analysis
• United Technologies Corp. (UTX) – Traditional: 35% – FCF Payout: 30% – Analysis

Sometime the gap is much larger. This could have resulted from significant non-cash charges on the income statement.  Companies with large gaps include:

• Aflac Incorporated (AFL) – Traditional: 44% – FCF Payout: 10% – Analysis
• CenturyLink Inc. (CTL) – Traditional: 87% – FCF Payout: 46%
• Diebold Inc (DBD) – Traditional: 74% – FCF Payout: 30%
• Illinois ToolWorks Inc. (ITW) – Traditional: 76% – FCF Payout: 31% – Analysis
• Leggett & Platt Inc. (LEG) – Traditional: 262% – FCF Payout: 34% – Analysis
• Nucor Corporation (NUE) – Traditional: 88% – FCF Payout: 29% – Analysis
• Pitney Bowes Inc. (PBI) – Traditional: 73% – FCF Payout: 38%
• PPG Inds Inc (PPG) – Traditional: 158% – FCF Payout: 48%
• RLI Corp (RLI) – Traditional: 158% – FCF Payout: 48% – Analysis
• RPM International Inc (RPM) – Traditional: 84% – FCF Payout: 49% – Analysis
• AT&T Inc. (T) – Traditional: 81% – FCF Payout: 49%

Sometimes the gap is not only large, but goes the other way. This is potentially the most dangerous since focusing on the traditional dividend payout may lead you to believe the dividend is covered better than it actually is. Examples of this situation would include:

• Air Products and Chemicals Inc. (APD) – Traditional: 56% – FCF Payout: 172%
• Franklin Resources Inc. (BEN) – Traditional: 23% – FCF Payout: 48%
• BP Plc (BP) – Traditional: 50% – FCF Payout: 114% – Analysis
• Lowe’s Companies, Inc. (LOW) – Traditional: 27% – FCF Payout: 57% – Analysis
• Exxon Mobil Corp (XOM) – Traditional: 27% – FCF Payout: 54%

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 CLX, EMR, MMM, SYY, UTX, AFL, CTL, ITW, NUE, BP. See a list of all my income holdings here.

(Photo Credit)

To identify these stingy companies, I used the following criteria on the companies I track:

• A Free Cash Flow Dividend Payout (FCFp) of 40% or less. This means that 60% of the company’s cash, after operating expenses, is going elsewhere.
• A sum of Debt to Total Capital (Debt) + FCFp of less than 50%. This should help weed out the companies holding the cash to pay interest.
• Trailing 12-month Free Cash Flow per share is greater than an average of the last 3 years. This weeds out companies where cash flow is decreasing.
• Cash on the balance sheet in excess of short-term debt. This weeds out companies that may have an immediate debt-servicing need for the cash.

Here are seven stocks out of the 100 that I track meeting the above criteria:

Aflac Incorporated (AFL) – 4-Stars – Analysis
Aflac Incorporated engages in the marketing and sale of supplemental health and life insurance plans in the United States and Japan.

• FCF Payout: 10%
• Debt + FCFp: 34%
• Cash/ST Debt: 11.5 Times

C.R. Bard Inc. (BCR) – 4-Stars
Bard (C.R.) Inc is a diversified producer of therapeutic and diagnostic medical devices has exposure to the vascular, urology, oncology, and specialty surgical markets.

• FCF Payout: 13%
• Debt + FCFp: 19%
• Cash/ST Debt: No ST Debt (4.1 Times LT Debt)

Franklin Resources Inc. (BEN) – 2 Stars
Franklin Resources Inc. is one of the world’s largest asset managers, serving retail, institutional and high-net-worth clients.

• FCF Payout: 17%
• Debt + FCFp: 31%
• Cash/ST Debt: 91.2 Times

Donaldson Company (DCI) – 3 Stars – Analysis
Donaldson Company operates as a worldwide manufacturer of filtration systems and replacement parts.

• FCF Payout: 17%
• Debt + FCFp: 49%
• Cash/ST Debt: 1.6 Times

General Dynamics (GD) – 2 Stars – Analysis
General Dynamics is the world’s sixth largest military contractor and also one of the world’s biggest makers of corporate jets.

• FCF Payout: 25%
• Debt + FCFp: 48%
• Cash/ST Debt: 1.2 Times

Lancaster Colony (LANC) – 2 Stars
Lancaster Colony is a diversified Ohio-based company manufactures and markets consumer products; glassware and candles; and automotive accessories.

• FCF Payout: 25%
• Debt + FCFp: 29%
• Cash/ST Debt: No ST Debt (1.3 Times LT Debt)

Walgreen Co. (WAG) – 3 Stars – Analysis
Walgreen Co is the largest U.S. retail drug chain in terms of revenues. It sells prescription and non-prescription drugs, beauty care, personal care, household items, candy, photofinishing, greeting cards, seasonal items and convenience foods.

• FCF Payout: 28%
• Debt + FCFp: 42%
• Cash/ST Debt: 230 Times

You could view this from a positive perspective and say the above dividends should be very safe and the companies are in an excellent position to continue to raising them each year.  In dividend investing, cash is king, but at some point management has to be willing to share it with the company’s owners.

Full Disclosure: Long AFL. See a list of all my income holdings here.