5 of the Safest Dividends on the Market

You’ve likely relied on this measure of dividend safety countless times: the earnings payout ratio.

The ratio shows the portion of earnings paid out in dividends. If a company earns $1.00 per share during the year and pays out $0.50 per share, then the payout ratio is 50%. This is considered a sustainable payout ratio because it leaves a cushion if earnings fall, and room to grow the dividend if earnings rise.

This ratio is deceptively simple. Look deeper, and you’ll see some cracks.

Dividends are paid in cash. But earnings are not cash. Earnings are an accounting device. They are the net income that results from matching revenue with expenses in the same period. The actual cash that’s received or paid may come later.

For example, AT&T (NYSE: T) reported $94 billion in revenue for the first nine months of 2011. But $13 billion of that consisted of accounts receivable, meaning services were rendered during the period but no cash payment was received for them. Still, a portion of those accounts receivable ultimately made its way to earnings.

Earnings can be a useful proxy for cash and the earnings payout ratio is a handy tool for many companies. But the difference between earnings (or net income) and the actual cash that pays your dividend is especially great for most high-yield companies. And that limits the usefulness of the earnings payout ratio.

In AT&T’s latest earnings statement, for example, depreciation expenses chopped $14 billion from the last nine months of earnings. But depreciation is a non-cash expense. It simply shows that AT&T’s fixed assets — its wireless and landline networks and equipment — are losing value from wear and tear, aging, or technology changes.

AT&T is not alone. Most high-yield stocks can pay out big dividends because they generate huge amounts of cash flow year after year from fixed assets — pipelines, shopping centers, oil tankers. These assets lose value as they age, so they generate a lot of depreciation expense. This expense cuts into earnings but doesn’t affect the safety of your dividends.

A more precise measure of the real cash that flows through these businesses is cash flow. Cash flow is what companies have left after paying salaries, rent, bills, interest on debt and taxes. It’s called “net cash provided by operating activities” in the first part of the company’s statement of cash flows.

So, can we substitute cash flow for earnings in the payout ratio to get a better measure of dividend safety for these high-depreciation companies? It’s not that easy.

A lot of other uses for the cash flow take priority over dividend payments. To keep the business growing, management needs the cash flow to make large capital expenditures — upgrade networks, buy oil tankers, develop properties. And before shareholders get paid, debtholders are first in line. Debt payments are a contractual obligation; dividends are a discretionary expense.

So, what’s the bottom-line metric that tells you, after all necessary expenses, what the company really has left for shareholder dividends?

The best tool I have found is a little known metric called free cash flow to equity (FCFE). This tells you after all expenditures how much operating cash flow actually remains for shareholders. FCFE strips out all capital expenditures and adds back net borrowings that can be used to pay dividends.

Here’s the formula:

FCFE = Cash flow from operations – Capital expenditures + Net borrowings

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 website such as Yahoo! Finance. “Levered free cash flow” on Yahoo’s Key Statistics page is similar to free cash flow to equity.

However, the 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 during the past year. So, I added a performance criterion, reasoning that out-performing 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 in the past year:

Risks to Consider: 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.

Action to Take –> 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.

P.S. — One stock gives you a stake in dozens of oil wells while paying an 11.5% yield. Another returned a gain of 13% in the last bear market and yields 8.8%. Another has raised dividends 205% since going public in 2001. These are the type of investments that make up StreetAuthority’s latest “Top 5 Income Stocks for 2012” report. To learn more about these high-yielding picks for the coming year, visit this link.