Why Dividends Don't Tell the Whole Story

With interest rates near record lows, Fools may be tempted to reach for high dividend yields in the quest for income.

Don't!

As my fellow Fool Anand Chokkavelu points out, stocks that offer high yields are often priced that way for a good reason ... the underlying business stinks.

Besides, there is a better "yield" to look at when searching for winning stocks, and there are plenty of great blue chips available right now by this measure (more on that in a moment).

Why dividends aren't the whole picture
There are plenty of things a company can do with its free cash. Paying a dividend is only one option, and typically not the preferred one. As the owner of a business, you hope to reinvest your winnings in profitable projects that can make you even more money down the road.

That is what virtually all businesses do. They retain at least some free cash to fuel future growth, so that when paid out as a dividend, it's bigger than it would have been otherwise.

Think of it this way: Companies choose not to pay a dividend for the same reason that you to choose to invest and save. You could spend all your savings on a fancy house or car now, but you choose to invest so you can buy an even bigger house later on. This is what a company is doing when it reinvests free cash flow rather than pays it out. It is saving and reinvesting for you. (And you can always undo the company's decision by selling some shares.)

While it's true that dividend payers have historically beaten the market, the fact that they happen to pay a dividend is probably not the cause. Companies with a consistent history of paying dividends tend to be the leaders in their fields. Their superior performance is probably due to this fact, and not the payment of the dividend itself.

Taking an inferior business and having it pay dividends won't give it better returns.

Blue chips on fire sale
So what we need is an honest yield that takes into account not just the cash distributed as a dividend, but all the cash generated by the business -- reinvested or otherwise. Ideally, this measure should be immune to manipulation by management.

The closest thing that fits the bill is something called "cash return": free cash flow divided by enterprise value (FCF/EV).

The numerator is the annual free cash generated by the firm, and the denominator is the true cost of the business once you take debt and pre-existing cash into account. By dividing the true cost of buying the firm into all the cash generated, you get the actual yield of the business.

Another way of looking at cash return is as the annual return you earn on the operating business assuming it stops growing from here!

And while the S&P 500's dividend yield of 1.8% makes the market look weak, looking at cash return yields (pardon the pun) a different story.

When I ran a screen for stocks with market caps above $10 billion that have cash returns of 10% or more, I came up with 16 great candidates. (I excluded bank stocks from consideration because the cash flow statement isn't very meaningful for them.)

In this group is biotech powerhouse Amgen (Nasdaq: AMGN  ) , which turns every $1.00 of sales into more than $0.33 of free cash. That's a strong result, but if you focused solely on dividend stocks, you'd completely miss out on the stock, because Amgen doesn't pay a dividend.

Sometimes, however, a high dividend yield understates the truth. Such is the case with Verizon Communications (NYSE: VZ  ) . The stock's rotund dividend yield of 5.4% is supported by an 11.6% cash return. Given Verizon's reputation and recent iPhone score, receiving 11.6% doesn't seem so bad.

While Fool Eric Bleeker may think Intel (Nasdaq: INTC  ) is destined for the garbage dump, its 10% cash return shouldn't be ignored. Did anyone besides me notice Google chose the Intel Atom to introduce the cloud-based Cr-48 to the press? And if ARM Holdings becomes too big of a threat, Intel could simply buy out the company. (Hey, the regulators let Oracle take out PeopleSoft.)

Some Fools may attempt to play the economic recovery with retail stocks. If so, they could do a lot worse than Gap Stores (NYSE: GPS  ) . The company has no debt (unusual for a retailer) and a cash return over 11%, providing a margin of safety in case the recovery doesn't work out as planned.

In addition to the aforementioned are pharmaceutical giant Eli Lilly, anticomputer-virus star Symantec, and Dell, which I've chronicled elsewhere.

The bottom line is this: There's tons of "yield" in this market if you take a more all-encompassing view of how companies generate cash.

Fool contributor Chris Baines owns shares of Dell. Google and Intel are Motley Fool Inside Value picks. Google is a Motley Fool Rule Breakers recommendation. The Fool has written puts on Apple, which is a Motley Fool Stock Advisor selection. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended buying calls on Intel. The Fool owns shares of Apple, Google, and Oracle. 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.


Read/Post Comments (6) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 31, 2011, at 5:37 PM, Fool wrote:

    Chris,

    Not to be contrarian to your article, but are you looking at FCF/Sales or FCF/EV?

    I would consider FCF/Sales to be representative of how efficiently a firm turns revenues into cash. The example you gave of Amgen churning out $0.33 of cash for every $1 of sales shows that they are very good at this metric.

    But, this is not the same thing as FCF/EV, which is more of a company valuation. EV is the company's Market Cap + LT Debt - Cash & ST Investments. This takes into account everyone who has a stake in the company: both equity and debt holders.

    The reason I bring all of this up is, it is very possible for a company to have a very high (attractive) FCF/Sales metric and also a very low (unattractive) FCF/EV valuation. Especially if they are highly leveraged -- meaning the FCF is bogged down by an excessive amount of debt on their Balance sheet.

    I think it is fair to focus on companies with either high FCF/Sales ratios or high FCF/EV ratios, though I wanted to point out that these values are not necessarily telling the same story.

  • Report this Comment On February 01, 2011, at 2:12 AM, cbaines2 wrote:

    TXinvestor: FCF/Sales is a profitability metric like 'profit margins'. FCF/EV - like you say - is a valuation metric...like dividend yield or PE. Since I was making the argument that these companies are attractively valued, I used FCF/EV.

    truthisntstupid: Good question! Yes, you are correct about the net interest expense...you should add it back. And I did for the calculations in the Fool piece.

    In finance there is "free cash flow to equity" and "free cash flow to the firm." Both are commonly referred to as "Free cash flow". We do this to confuse people, lol. :-)

    The kind where you add back net interest expense (with an adjustment for taxes) is free cash flow to the firm...which is what I used for my calculations.

    I didn't want to get bogged down with explaining the distinction between the two for this article, it part because the companies I profiled generally have minimal interest expense (relative to operating cash) anyway. So it doesn't make a heap of difference for them. For GAP it makes no difference at all (that have no debt)!

    Hope that helps,

    Chris Baines

  • Report this Comment On February 01, 2011, at 11:54 AM, ChrisFs wrote:

    The difference is that dividends are cash in hand, whereas a great cash generating machine with no dividends can remain at a bargain price for a long time until the market realizes the deal that it is.

  • Report this Comment On February 01, 2011, at 12:14 PM, PostScience wrote:

    Companies that don't pay dividends often don't invest their cash wisely.

    If a company hoards cash, it is preventing me, the investor, from finding a better return somewhere else.

    But if a company squanders the cash on acquisitions, it is far worse. A mature company like the Gap doesn't need to be making acquisitions or substantial capital investments.

  • Report this Comment On February 02, 2011, at 12:58 AM, cbaines2 wrote:

    PostScience....There is truth to what you say about management squandering cash.

    The problem there, though, is not so much with the dividend policy as it is with management. A company with a generous dividend policy can still abuse shareholders if the management is not entirely on the level (cough....AIG, Bear Sterns).

    So while I'd agree that stocks that pay dividends may be less prone to wasting cash, they can still run into other problems. Furthermore, the fact that some companies without dividends may waste cash doesn't mean that they all do - case in point, Berkshire Hathaway.

    Thanks,

    Chris Baines

  • Report this Comment On February 02, 2011, at 12:59 AM, cbaines2 wrote:

    Oh...and GAP actually pays a sizable dividend. :-)

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