From Dividend Growth Stocks:
New income investors naturally focus on yield, but the highest yielding stocks aren’t always the best investments. To find the very best dividend growth stocks, an investor must identify companies that will not just sustain their dividends, but increase them every year. To find these jewels in the rough, there are two very important things the investor must look for.
First, dividends are paid in cash. Therefore, if a company is going to pay a dividend, it must have cash available. If the company is going to consistently pay and grow its dividend, it must have a vibrant business model that generates a growing level of cash. Unfortunately, most businesses have a degree of variability in which earnings and cash don’t grow in a smooth line.
Free Cash Flow Payout
How well a company can absorb these ups and downs is reflected in its free cash flow payout. Free cash flow payout is calculated as dividends divided by free cash flow (operating cash flows less normal capital replacements). Components of free cash flow are found on the Cash Flow Statement. Free cash flow tells you how much cash the company has left over after paying the normal operating expenses. This is the cash used to pay for acquisitions, debt obligations, and dividends!
Debt To Total Capital
It is not enough to just generate the cash. It has to be available for dividend payments. Many companies generate significant free cash flow, but often that cash is already spoken for in the form of debt obligations. To gauge the relative amount of debt a company is carrying, I look at…