Free Cash Flow And The Dividend Coverage Ratio: Attributes Of A Good Dividend Stock

2008 May 13

by Kyle

from → Investing And Investments, Passive Income

Free Cash Flow is a firm’s net income plus depreciation/amortization and all other non-cash charges – minus changes in working capital and capital expenditures. It may sound complicated at first glance, but all that really means is that free cash flow is the amount of cash left over after paying the bills and making new investments and on-going capital improvements. Earnings include plenty of non-cash components such as depreciation of equipment, amortization of capital expenditures, provisions for bad debts, and a multitude of other accounting entries which may or may not reflect current economic reality. Earnings can be easily manipulated through all manner of accounting gimmickery. Enron was “earning” money right up to the end. Free cash flow, on the other hand, is very difficult to manipulate. You can’t fudge cash in the bank.

The Dividend Coverage Ratio

Last time, we talked about how a low payout ratio can be indicative of a quickly growing future dividend stream. We’re going to go one step further and examine the dividend coverage ratio as an even better predictor of dividend safety. The dividend coverage ratio is simply by free cash flow per share divided by cash dividends per share. There are several reasons to prefer the dividend coverage ratio over the payout ratio. A ratio of less than one indicates the company is burning through more cash than it’s taking in and a dividend cut is likely. A ratio of 2 would be considered acceptable while a ratio of 3 or even 4 would be ideal.

As we saw above, earnings is pretty easy for management to manipulate favorably. Not only that, but not all earnings are truely available for distribution to shareholders. All companies need to retain at least some percentage of their earnings to maintain facilities, invest in new equipment, fund research and development, and generally keep things running smoothely. Were a company to pay out 100% of earnings without reinvesting anything back into the business, its asset base would eventually become obsolete and the company would face bankruptcy.

By definition, free cash flow is the amount of cash that can be taken out of the business without impairing future results. Since it takes capital expenditures into account, 100% of free cash flow is available for distribution to shareholders. This gives you a much better idea of exactly how large a dividend the company can afford to pay than if you rely on earnings alone.

Attributes Of A Good Dividend Stock

Check out the rest of the series