Searching for a good dividend stock is straight forward, but it can be easy to gloss over deeper problems. Many people look at a few basic metrics like the dividend yield, the dividend payout ratio and the revenue growth rate, and then create a dividend portfolio. This process ignores the quality of a company’s cash flow, which is very important.
The search process
Many investors look for a stock with a yield around the market average and a payout ratio less than 50. A payout ratio less than 50 means that less than 50% of the cash for the dividend comes from earnings. It is common to throw in growing earnings per share (EPS) and growing revenue to get a good looking dividend growth stock.
The chart below shows how Chesapeake Energy Corporation (NYSE:CHK) was marching along with a healthy payout ratio below 50, until its earnings plummeted and its payout ratio fell like a rock. This energy firm was a natural gas growth play. It looked like an attractive way to ride America’s fracking boom and pick up dividends on the side. Now, its stock price has remained at depressed levels since 2009, and it still has a high total debt to equity ratio of 1.06. Hindsight is 20-20, but was there any simple way to predict Chesapeake’s poor performance?
Look at free cash flow
Free cash flow (FCF) isn’t mentioned as commonly as revenues or EPS, but it is a powerful metric that reveals the quality of a company’s earnings. FCF is the cash that a company generates from operations, less capital expenditures. It helps to show how much cash a company can generate from operations, in a sustainable manner.
As the chart below shows, Chesapeake Energy Corporation (NYSE:CHK) has consistently produced negative per share FCF. Given Chesapeake’s business model of buying up as much land as possible and taking on large amounts of debt to drill as many wells as possible, it isn’t surprising that the company hasn’t turned out very well. Chesapeake’s lack of FCF comes with the questionable practices of its former CEO.
Companies with strong free cash flow and low payout ratios
While Chesapeake Energy Corporation (NYSE:CHK) is a good example of a company with low FCF that is best avoided, Union Pacific (NYSE:UNP) is the opposite. This railroad has maintained a payout ratio around 30 and positive FCF. Its network runs from America’s Midwest to the Pacific Coast. The company has a great value proposition for companies that import and export goods from Asia. The company is in a stable position. The capital and regulatory hurdles required for creating a network that could rival Union Pacific’s are enormous.