Measuring Dividend Quality With Genuine Parts

With short-term Treasuries currently yielding zero percent and economic growth likely to remain subpar for years, dividend coverage and safety is becoming increasingly important to investors. It's common for analysts to use earnings to determine dividend coverage. The way management manipulates earnings, though, it might be more prudent to utilize some other measure.

In my opinion, free cash flow is a far superior method; it's easy to find the numbers to do the simple arithmetic required, and it's real money, not Wall Street money. Lots of free financial Web sites provide enough data to determine any given stock's free cash flow in their financial statement sections. To calculate it, simply go to the statements of cash flows in the most recent annual report, locate capital spending under investing activities and subtract it from cash from operations. It's that easy.

Do not use earnings before interest, taxes, depreciation and amortization or variations; they're useless for our purposes. Free cash flow is real cash left over from the company's primary business operations after accounting for everything, including taxes, salaries, pension plan contributions, maintenance and spending for growth. Everything. Basically, it's mad money.

Be sure to do this for all three years in the table. You don't want just one year of good free cash flow; you want consistency. Wall Street applies huge haircuts (discounts) to stock prices for uncertainty of any kind. You're looking for free cash flow that's approximately the same level as earnings or higher, year after year.

In the financing activities section of the cash flow statement, locate the dividends line, and divide your free cash flow by that amount. You are looking for a free cash flow/dividend ratio well above 1.0, preferably 1.5 for a really stable business and higher for a less stable business model. You also have to take into account the likely stability of the business model during recessions, or else the whole exercise is pointless.

To illustrate, let's compare AutoZone (AZO - commentary - Cramer's Take) and Genuine Parts (GPC - commentary - Cramer's Take).

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At the time of publication, Loest had no personal positions in any stocks mentioned outside his holdings of the Integrity Growth & Income Fund and the Williston Basin/Mid-North America Stock Fund, which he manages.

Robert Loest is a financial analyst charterholder (CFA). He has managed money for institutions and individuals since 1987 and is frequently quoted in the press. He has appeared as a regular or occasional guest on many financial programs, including CNNfn, CNN, CNBC, Fox Financial News, Bloomberg, Wall $treet Week with Louis Rukeyser and two years as a regular panelist on CNBC's ?Market Week with Maria Bartiromo,? broadcast from the floor of the NYSE.

Loest employs a value-based, bottom-up approach to stock selection. He invests in companies that consistently generate high amounts of free cash flow and demonstrate high returns on invested capital. He estimates a fair value based on discounted FCF, and typically purchases stocks only at a discount to estimated fair value. He also employs various risk management tools to minimize the level of risk. His primary objective is to generate high risk-adjusted returns.