Safety In Yield
Rupert is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The hunt for yield can be tricky; while many companies have low payout ratios from EPS some yields can prove to be too high for companies to sufficiently cover them from their free cash flow.
Take Chevron (NYSE: CVX) for example, it yields a respectable 3.4% and the dividend appears to be relatively well covered with a payout ratio of only 30%. On the other hand looking into the detailed cash flow of the company we can see that dividend payments represent a whopping 71% of free cash flow!
With EPS figures being calculated after the deduction of debt payments and share issuance, they provide a different figure to free cash flow.
The final free cash flow figure does not take into account the distribution of dividends, issuance/reduction of debt and any issues/buybacks of shares. This presents a very different picture, as all these financial cash flows are calculated after, the free cash flow figure has been produced.
The final figure after shareholder distributions and debt repayments results in a negative cash flow figure. Obviously a company running this kind of yearly cash flow deficit will need to lean heavily on debt or cash reserves to continue operating; possibly putting a strain on future shareholder returns.
At the other end of the scale we have the high yielding Seagate Technology (NASDAQ: STX). The company is currently suffering poor sales due to changing technology. As a manufacturer of hard disks the company is coming under pressure from flash disk producers.
On the face of it, Seagate appears to have a very good yield of 5.4%, with a payout ratio of 20%. From this point of view the dividend looks safe with room for improvements.
Looking into the cash flow Seagate presents a very different picture to Chevron. With dividend payments only accounting for 16.5% of free cash flow the dividends from Seagate appear to be more secure, based on the size of the available cash flow they represent. Once again however Seagate does have another negative cash flow, resulting on the possibility of needing to borrow.
Cisco Systems (NASDAQ: CSCO) is at the moment one of the most fiscally prudent firms in the S&P 500. Although its dividend is not the best, it is highly secure.
With dividend payouts, share buybacks and debt reduction costing less than the total free cash flow available, Cisco is able to retain a large amount of profit as cash. This retention is helping to bolster the balance sheet, and there is also scope for significantly improved cash return for shareholders.
The free cash flow that is generated by each company can be useful in deciding how large shareholder returns will be in the future. With a company generating a large free cash flow after shareholder returns, it is able to retain cash for reinvestment in future years, or continue to return cash to shareholders during times of reduced revenue.
When searching for yield it pays to look for the payout ratio, to establish how viable the current dividend is, from the EPS the firm is currently generating. A more telling indicator however is the cash flow as it will often highlight troubles that cannot be seen in the payout ratio. Even if it does not it is useful for projecting future shareholder returns.
RupertHargreav has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Cisco Systems and Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!