Cash Flow: The Key to Dividend Stocks

Dividend investing may look easy to some, but it’s much more difficult than just selecting stocks with the highest dividend yields.


Many novice investors focus all of their attention on stocks offering the highest yields. After all, the dividend income is why they are considering these stocks in the first place. So picking the stock that offers the highest dividend payment seems to make sense.


Unfortunately, many of these investors soon learn that there is more research needed than just evaluating a stock’s dividend yield.


Some investors will take the next step and evaluate the company’s ability to continuing paying their dividend. Unfortunately, most investors just look at earnings per share (EPS). If a stock earns $2 per share and pays out $1 per share, it would seem to have a safe dividend.


Of course the novice investor doesn’t understand the intricacies of GAAP accounting. A prudent investor digs beyond net earnings to look at a company’s cash flow. There are many methods for manipulating quarterly earnings, but it’s much more difficult to manipulate cash flows (at least legally).


The key to evaluating dividend stocks is cash flow! If there is only one factor that you use to evaluate dividend stocks, it should be their cash flow and specifically their free cash flow.


Free cash flow is actually very simple to calculate. On a company’s statement of cash flows, just subtract their cap ex spending from their operating cash flows. The result is the free cash flow that they can use for dividends, stock repurchases, acquisitions, etc.


Let’s take a look at a couple of blue chip dividend stocks as examples:


Procter & Gamble

P&G is one of the most famous dividend stocks in the world. The consumer goods stock has been paying dividends since 1890 and has increased their dividend for 54 consecutive years. In fiscal year 2009, PG posted $14.9 billion in operating cash flow and $3.2 billion in capital expenditures. That resulted in $11.7 billion in free cash flow. During that time, P&G paid $5.0 billion in dividends to their investors. Since P&G is only using 43% of their free cash flow to fund their dividend payments, investors should feel very comfortable that the stock is safe. The low payout ratio is also an indication that investors can continue to expect dividend increases in the future.


American Electric Power

AEP is an electric utility with an attractive 4.9% dividend yield. The stock pays out $1.68 per share in annual dividends, but Wall Street expects the company to earn $3.03 per share. However, taking a look at the company’s cash flows statement reveals some warning signs. Last year, AEP generated $2.48 billion in operating cash flow, but also paid out $2.79 billion capital expenditures. That resulted in negative free cash flow. In this situation a company has to either borrow money to pay their dividend or cut the dividend payment.


While some company’s may experience negative free cash flows on an occasional basis, investors should take warning if the trend continues.


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