Are These Dividends Going to Be Around for Long?

Let's face it, dividends aren't all that sexy. While rule-breaking stocks may zoom up or down 100% in a year's time, dividends are the tortoise to the rule-breaking hares.

But if anyone had a doubt about the power of dividends, they need only read Jeremy Siegel's The Future for Investors. In it, he writes: "Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run."

An important metric for dividends
The utility sector, in particular, is a gold mine for dividend investors, where the average industry yield is about 4%. Knowing how important dividends can be, it's important to examine how sustainable a company's dividend is.  

One of the most popular metrics used to measure a dividend's sustainability is the earnings payout ratio. In essence, this measures how much of a company's earnings are used up in paying out dividends. As theory goes, the lower the payout ratio is, the more sustainable the dividend is.

Take a look at the table below. It includes seven popular utility stocks and their payout ratios.

Source: Yahoo! Finance.

In their book Million Dollar Portfolio, David and Tom Gardner suggest that you should only hold stocks that have a payout ratio of less than 65%. Clearly, this would make the cautious Fool worry about the sustainability of dividends from companies such as CenterPoint and Southern (this hasn't, however, stopped Southern from being an active recommendation in the Motley Fool's Income Investor newsletter).

But wait, there's more!
This is where things get tricky. Because earnings are reported using the accrual method, all of the money that a company says it's earned hasn't necessarily been paid to it yet. Things like accounts receivable and payable, depreciation and goodwill are included in earnings -- and they don't immediately affect the amount of money a company has in the bank.

The good news is that there is -- in fact -- a way to check how much money a company has put in the bank: free cash flow. This number is very (some Fools say more) important in evaluating a company's dividend sustainability. In the end, dividends are paid from free cash flow, not from earnings.

Check out the free cash flow payout ratio for these companies, and the story changes considerably.

Source: Yahoo! Finance.

Wow! That really changes things. Using earnings to calculate payout ratio, we had five safe dividends earlier in the article, but when we dove into free cash flow -- which is what dividends are paid from -- we see that we only have one safe play left: CMS Energy.

How can this be?
It's no secret that capital expenditures are enormous for utilities, and when a company needs to build out or improve upon their existing infrastructure, cash flow can disappear.

Sometimes this is just a short-term problem, but other times, it's a serious cause for concern. Let's take a look at these companies' average annual free cash flow over the past five years.

Again, things change a ton when we look at dividends from a third point of view. Take Southern, for example. The company has sky-high payout ratios over the past year when looking at earnings and cash flow. But when we zoom out and look at five-year averages, we see that Southern produces the most free cash flow by far of the group.

Foolish takeaway
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