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Screening for Sustainable Dividends

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( MagicDiligence.com) -- MagicDiligence has written several times about using the official Magic Formula Investing (MFI) screens as a starting point for locating attractive dividend stocks.

There are two main reasons this is true. First, MFI screens for high-earnings yield. This has the effect of finding undervalued stocks where the dividend yield is likely to be higher than normal. Also, since it screens stocks cheap against their trailing earnings, it also creates opportunity for capital gains in the stock price, in addition to dividend payments.

Second, the screen also looks for high returns on capital. High returns on capital are often a sign of a company with competitive advantages, and/or one that is well run by a competent management team. These kinds of companies are more likely to be able to sustain a dividend payment than ones that are poorly run or have few competitive advantages.

Of course, dividend stocks are most useful when utilized as a source of stable income, preferably when the dividend payout can be counted on to grow over the years. There are several Magic Formula stocks with dividend yields that can be considered high (over 3%). But how can we determine if the yield is sustainable and likely to go up in the future?

Payout Ratio of Free Cash Flow

One common way to measure the sustainability of a dividend is through the payout ratio. For most financial sites, this is the amount paid out in dividends divided by net income over the past 12 months. But this is not really the best way to do it.

Net income includes many non-cash items such as depreciation, stock-based compensation, goodwill and intangible asset write-downs, and even tax provisions do not reflect the true amounts of cash that are flowing into and out of the business. This is where the cash flow statement comes in.

Since the cash flow statement tells us directly how much cash was produced by the business ("cash from operations"), we don't need to guess! Also, we need to subtract capital expenditures needed to maintain the business: The result is known as free cash flow. This is the best figure to use when calculating dividend payout ratio, instead of net income.

So: Payout Ratio = (Cash Dividends Paid / (Cash from Operations - Capital Expenditures) )

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