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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.


) -- MagicDiligence has written several times about using the


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) )

How to Use Payout Ratio

The payout ratio is the first step in determining sustainability. A payout ratio consistently under 50% indicates a pretty stable dividend. A payout ratio under 30% indicates the potential for a near-term dividend boost. Payout ratios over 50% need to be looked at closely. Have cash flows been stable over the years, and do they look to continue that stability? Does the company have sustainable competitive advantages?

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Many firms have stable businesses with few growth prospects, and as such elect to pay up to 75% of their cash flow out as dividends. MFI examples of these include tobacco companies and large pharmaceutical firms.

Good Dividend Example: Intel

The best situation is a low payout ratio combined with a stable business and solid growth prospects. This allows the firm to enact significant dividend increases as free cash flow rises and the potential for a higher payout ratio increases as those growth prospects mature.

An example of this is a company most everyone is familiar with


(INTC) - Get Intel Corporation (INTC) Report

. Intel, of course, makes the processors that form the "brains" of most desktop, laptop, and server computers, as well as related products like chipsets, graphics processors, and memory.

Computing devices continues to be a growth industry as emerging economies around the world develop and ever-more powerful devices enter the market. It is also a relatively stable business due to the consumable nature of devices (most computers last only three to five years). Intel has dominated the industry for over 30 years.

Taking a look at the firm's dividend metrics:

Here we see everything that makes a good, sustainable dividend pick. The current yield is sufficiently high at 3.2%. Intel has a history of steady and rising free cash flow, even through a tough recession in 2008-09. Payout ratio never exceeded the 50% red flag line, and in fact has remained in relatively low territory. All of this has allowed Intel to raise the per share dividend at a compound rate of 11% annually since 2006. This is a solid, long-term dividend stock pick.

Not as Good Dividend Example: USA Mobility

We also need to flip the coin and examine cases where the dividend may not be sustainable. It is time to be concerned when you see a payout ratio over 50% and steadily declining free cash flows. Usually a company will try to sustain the dividend for as long as it can, so there will be no dividend hikes, but payout ratio will steadily rise as the free cash flow component shrinks. Eventually, management is forced to cut the dividend in order to conserve cash and in many cases invest it in new businesses that will not decline as significantly.

MFI has a few examples of these, but perhaps the most glaring is

USA Mobility


. USMO is a pager service company. Yes, pagers do still exist, primarily used by the healthcare and emergency response (fire / ambulance) industries. Naturally, though, it is a dying business as newer technologies have already taken over the consumer market and will eventually do so here as well.

Here are USMO's dividend metrics:

All kinds of red flags here. For one, free cash flow has been on a steady decline since 2006, and now stands at only about half of what it was five years ago. We see in the 2006-07 period how payout ratio reached unsustainable levels, leading to a 60% dividend cut in 2008. After a hike in 2009, we've seen a freeze in dividend hikes, and now payout ratio is starting to creep up into worrisome territory again. Could another cut be far off?

USA Mobility also did what most declining businesses have to do -- use cash to diversify into new, growing businesses. The company used $163 million to purchase Amcom Software in March, entering the growing communications software business. The difficulty here is that Amcom only generates about 14% of what USA Mobility's legacy pager businesses generate, so it is not quite enough to offset continuing declines.

There's no question that USA Mobility's current yield of 6.5% is highly attractive. But it is likely not sustainable over the long term.

Steve Alexander owns no position in any stocks discussed in this article.