'Secret' Metric Unearths 5 Stock Gems

02/08/2012 10:00 am EST

Focus: STOCKS

Carla Pasternak

Editor, The Income Investor

If there's one thing you need to find out about a company, it's how much money it really has to pay out dividends, writes Carla Pasternak of High-Yield Investing.

The best tool I have found to determine what a company really has left after expenses for shareholder dividends is a little-known metric called free cash flow to equity (FCFE).

FCFE strips out all capital expenditures and adds back net borrowings that can be used to pay dividends. Using FCFE in the denominator of the payout ratio, instead of more traditional earnings measures, can help separate the safer dividend plays from the more aggressive ones.

Companies aren't required to give this measure in their earnings reports, and most don't. You can get a rough estimate from a free financial Web site, such as Yahoo! Finance.

"Levered free cash flow" on Yahoo's Key Statistics page is similar to free cash flow to equity. However, their formula uses earnings before taxes instead of operating cash flow, and assumes a corporate tax rate of 37.5%, which may not apply. So, you may need to calculate the numbers yourself.

But don't worry. That's what I'm here for.

In my search for dividends that are well covered by existing FCFE, without an immediate need to be bolstered with more debt or equity capital, I was surprised. I found dozens of stocks with yields of 5%-plus that also had FCFE payout ratios of around 50% or lower over the past year.

So, I added a performance criterion, reasoning that outperforming stocks are poised to lead the charge should the market rebound in the year ahead.

Below are the five stocks I found with the highest dividend yield and lowest FCFE payout ratio that also outperformed the S&P over the past year:

  • Lockheed Martin (LMT) has a yield of 4.8% and a FCFE payout ratio of 24%. The stock's 52-week return has been 10.3% versus a 4.1% gain in the S&P 500.
  • Brookfield Infrastructure (BIP) has a yield of 4.9% and a FCFE payout ratio of 37%. The stock's 52-week return has been 39.3%.
  • Eli Lilly (LLY) has a yield of 4.9% and a FCFE payout ratio of 32%. The stock's 52-week return has been 19.9%.
  • Verizon (VZ) has a yield of 5.1% and a FCFE payout ratio of 42%. The stock's 52-week return has been 14.9%.
  • Alliance Resource (ARLP) has a yield of 4.9% and a FCFE payout ratio of 37%. The stock's 52-week return has been 22.1%.

Now, the FCFE payout ratio is a cash flow measure and nothing more. Just because the company has the free cash flow to pay the dividend doesn't mean it will. After meeting its obligations, management could decide to buy back shares with the free cash flow instead, or have some other use for the money.

Also, FCFE can vary greatly from year to year, so the payout ratio can also vary greatly. Still, well-managed companies with sustainable dividends tend to maintain a steady stream of FCFE over the long-term.

And if you're simply looking for a secure dividend payment, the list above is a good place to start.

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Related Reading:

Follow the Blue Chip Dividend Hikes

Court Rulings Shake Up Muni Markets

The Case for Small Firms with Big Yields

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