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