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Up an astonishing 1,192.8% with no end in sight

Get rich from the world's most BORING stocksI just published a report on my top 5 dividend stocks. One is up 630.8% since we added it to our portfolio. Another, I call “America’s best cash machine” because of its 8.2% yield. And a third is up 1,192.8%… with no end in sight. Best of all, these wonders pay juicy dividends and rake in top-notch gains in both bull AND bear markets. Get their names here.


Sustainable Dividends Depend on the Payout Ratio

By Jim Fink on June 7, 2012

By far, the most common question Investing Daily readers ask me is how to tell whether the dividends paid by a stock are “sustainable.” A perfectly understandable question given that many subscribers rely on dividends to meet their daily expenses and cannot afford to wake up one morning and read in the paper that monthly lifeline has been cut. 

Dividend Sustainability is More Important Than High Yield

When in doubt, I turn to income expert Roger Conrad of Big Yield Hunting for answers. Roger focuses on dividend sustainability more than any other topic.According to Roger, sustainable dividend yields are much more important than high dividend yields:

Everyone wants to buy into a big yield. The trouble is most people aren’t willing to put in the time to tell the good from the bad and ugly.

So how does one distinguish the shaky dividend vulnerable to being cut from the solid dividend primed to grow? According to Roger, it boils down to the underlying business. Always “buy the business”, not the yield:

It’s the underlying businesses that finance the dividends paid that are the clear line of demarcation, and where investors need to focus their efforts.

A Low Payout Ratio Determines Dividend Sustainability

Healthy businesses generate large amounts of cash flow and earnings. For a dividend to be sustainable, the amount paid out to subscribers must be well covered by the amount of cash coming into the business. How well the dividend is covered by actual cash is the measured by a term called the “payout ratio.” This ratio is the “one number” that Roger is talking about in the introductory quotation at the beginning of this article. Mr. Conrad describes the importance of the payout ratio this way:

The number I’m talking about will be no surprise to subscribers to any advisory I’ve contributed to over the years. It’s the payout ratio, which compares dividends to the profits that make them possible.

Generally speaking, the higher profits are relative to the dividend, the better protected that dividend is from setbacks at companies. A low payout ratio — which is the dividend as a percentage of earnings — is consequently the best possible sign that the dividend is indeed safe.

Different Ways to Calculate the Payout Ratio

The numerator of the payout ratio — dividends paid out — is easy to measure. The problem is how to measure the denominator, which refers to the cash coming in to the business. Should you use earnings or cash flow? As I wrote back in 2010 in Not All Earnings are Created Equal: Follow the Cash, earnings and cash flow can differ markedly in any given year. The reason is that earnings are based on accrual accounting, which attempts to match a company’s assets with its liabilities in a more relevant way that demonstrates the true profitability of the company over time. There is a lot of subjective judgment and discretion in accrual accounting that can lead to earnings manipulation.

In contrast, cash flows are, well, cash and there is no room for subjectivity (absent fraud). That’s the good news. The bad news is that cash flows can be very lumpy and not indicative of the continuous liabilities they are associated with. In the long run, earnings and cash flow converge; they have to since the only difference between them is one of timing recognition of cash.

Cash Flow or Earnings?

In those cases where earnings and cash flow differ markedly, I have to go with cash flow. In the short run, a dividend’s sustainability is based on the cash in hand, not on some subjective earnings accrual number. Consequently, I would avoid companies with high current earnings and much lower cash flow. UC-Berkeley accounting professor Richard Sloan has found through a number of academic studies that companies with low accrual ratios (cash flow higher than earnings) outperform companies with high accrual ratios (earnings higher than cash flow).

One of the main reasons that a company’s cash flow may be higher than it earnings is depreciation, a non-cash charge against earnings. Under accrual accounting, companies are required to depreciate their plant and equipment every year by a certain amount, even if the usefulness of the property has not been impaired.  Consequently, many capital-intensive businesses like local telecommunications companies, energy master limited partnerships (MLPs), and real estate investment trusts (REITs) have low earnings but high cash flows.

Of course, eventually, these companies will need to replace their plant and equipment with new purchases, which will cause their cash flows to take a big hit, but MLPs and REITs engage in period public equity offerings to replenish their cash coffers and local telecommunications carriers tap the debt markets regularly. I suppose if the equity and debt markets froze up like they did in 2008 these companies could face problems, but a repeat of 2008 appears unlikely anytime soon.

Follow the Free Cash Flow

Consequently, the best number to use for the denominator of the payout ratio is free cash flow. The word “free” refers to the cash flow available to pay out in dividends to common stockholders once all other claims on the company’s cash flow have been paid out. The definition of free cash flow starts with cash flow from operations (net income + depreciation + amortization), adds any cash proceeds from new debt, and subtracts out:

–         Preferred dividends

–         Capital expenditures

–         Changes in working capital needs (e.g., inventory, accounts payable, accounts receivable)

–         Debt repayment

As Roger explains, the key to paying dividends is distributable cash flow (i.e., free cash flow), not earnings:

Payout ratios based on earnings per share, however, are useless when it comes to measuring dividend safety at companies that are able to pay dividends from cash flow. For these companies distributable cash flow (DCF) is the essential measurement of profits. That’s basically cash flow excluding any one-time items and after taking out debt service and maintenance capital costs. What’s left is the cash generated by the business that it can use to pay dividends, cut debt, invest in growth or buy back stock.

Roger likes to see a payout ratio of less than 70%, though he is “willing to tolerate higher if the trend is moving in our favor – -i.e., earnings and cash flows are rising.”

Payout Ratio Ignorance Breeds Investment Bargains

Focusing only on earnings and ignoring free cash flows has led many income investors astray. For example, many investors have shied away from high-yield companies like Enterprise Products Partners (NYSE: EPD) because their payout ratios based on earnings are above 100%. By contrast, if these investors measured payout ratios properly based on distributable cash flow, they would discover that these companies’ dividends are well covered and have payout ratios far below 100%. In the case of MLPs and REITs, even free cash flow is misleading because their unique business models rely on continual and massive capital expenditures, so I look at operating cash flows for those two industries.

The misconceptions of many investors actually are a blessing for those of us dividend investors “in the know” because it allows us to pick up these high-quality companies at bargain basement prices.

Using my Bloomberg terminal, I performed a stock screen looking for companies that pay a 6% or greater yield, have a free-cash-flow payout ratio below 70%, and have dividends higher than earnings but lower than free cash flow for three consecutive years. Please note: MLPs and REITs don ‘t show up on a free-cash-flow screen because of their capex-intensive business models, so a separate screen based on operating cash flow would be needed to evaluate sustainability for those two industries.

I came up with five companies that might be undervalued because most investors are scared of them. The list is in ascending order of payout ratio:

Sustainable Dividends?




Free Cash Flow

Payout Ratio Based on Free Cash Flow

Supervalu (NYSE: SVU)

$74.2 million

-$1.0 billion

$395.0 million


R.R. Donnelley & Sons (NasdaqGS: RRD)

$194.2 million

-$119.1 million

$652.4 million


Regal Entertainment Group (NYSE: RGC)

$129.3 million

$110.2 million

$351.3 million


Fortress Investment Group (NYSE: FIG)

$42.8 million

-$357.6 million

$106.0 million


Consolidated Communications (NasdaqGS: CNSL)

$46.4 million

$20.8 million

$78.1 million


Source: Bloomberg

Of the companies listed, my favorite is Regal Entertainment because it has the best combination of low free-cash-flow payout ratio and positive earnings.

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  1. avatar
    frank tedeschi Reply June 10, 2012 at 3:07 AM EST

    Question: How do you determine if the dividend (distribution payment) of a REIT and/or MLP is sustainable? I believe the payout ratio analysis for a stock cannot be applied to a MLP or REIT since distribution payments are above 90%. Please explain for a person who likes to invest in MLPs and REITs in this low interest rate enviroment.

    • Jim Fink
      Jim Fink Reply June 10, 2012 at 12:16 PM EST

      Hi Frank,

      Excellent question! My understanding is that the 90% payout requirement only applies to REITs — not MLPs — and refers to income, not cash flow.

      In the case of MLPs, although tax law does not impose a 90% income distribution requirement, their limited partnership agreements typically require a “minimum quarterly distribution” based on “available cash.”

      Measuring dividend sustainability on free cash flow doesn’t work for REITs and MLPs because their business models are based on constant and massive capital expenditures, which overwhelm operating cash flow, causing free cash flow (operating cash flow – capex) to be negative in most years. The massive capex is funded by periodic and massive equity and debt issuances, which allows the business model to perpetuate the necessary cash inflows.

      Bottom line: my method for calculating payout ratio for REITs and MLPs is to divide cash distributions by operating cash flow and ignore the outflow of cash from capex, since I assume the company can cover capex through equity and debt issuances.