I was at a party last weekend and I ran into a friend I hadn’t seen for awhile. Knowing that I was in the investment business, he questioned me at length about potential dividend yield plays. Strong and consistent dividends can be a very attractive feature of any investment as they provide steady and growing income. However, my concern is that (along with my friend), many investors look only at dividend yields when choosing to invest capital.
I strongly recommend that investors interested in dividend paying stocks consider the existing source of that income and any potential growth in that income. Many will advocate focusing on earnings and the payout ratio (the dividend amount divided by earnings). While this is part of the process, I prefer to focus on free cash flow (cash from operating activities minus capital expenditures). We have discussed in previous articles the importance of cash flow. After all, a business is only as good as the actual cash flowing in and out of a business.
A healthy dividend yield is only as strong as the cash flow supporting it. Rather than screening for dividends, try screening for the cash flow that can provide dividends. When a company throws off sustainable cash, it has the flexibility for many positives such as paying dividends, buying back stock, or paying down debt.
The good news is that it’s fairly simple to analyze. Below is the statement of cash flows for Best Buy, Inc. We want to concern ourselves with the cash for financing activities section of this statement.
Net Income/Starting Line
Changes in Working Capital
Cash from Operating Activities
Other Investing Cash Flow Items, Total
Cash from Investing Activities
Financing Cash Flow Items
Total Cash Dividends Paid
Issuance (Retirement) of Stock, Net
Issuance (Retirement) of Debt, Net
Cash from Financing Activities
Total cash dividends paid is clearly broken out here. We can see that the dividend paid has been rising steadily – a good sign. We want to compare that payout to the actual amount of free cash being generated. A company’s dividend payout cannot exceed its free cash for long periods a time. We can see that Best Buy comfortably generates enough free cash flow to cover the existing dividend and then some. Furthermore, there is room for growth in the dividend in future years – very important.