FCF Yield and Dividend Investing: Finding Sustainable and Growing Payouts

A key concern for dividend investors is whether a company can maintain and ideally increase its dividend payments over time. Dividends are paid out of a company's profits, but reported earnings can sometimes be misleading (watch for red flags in FCF analysis) due to accounting adjustments, non-cash expenses, or one-time items.

Therefore, focusing solely on the earnings payout ratio (dividends paid divided by net income) can give a skewed picture of dividend sustainability. A company might show strong earnings but have poor cash flow, resulting in dividends that are not truly supported by operational cash generation.

Free Cash Flow is the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets (capital expenditures or CapEx). It represents the actual cash available to return to shareholders, pay down debt, or reinvest in the business.

FCF = Operating Cash Flow – Capital Expenditures (from the cash flow statement)

Because dividends are paid in cash, FCF is a more direct measure of a company's ability to sustain dividends than net income.

FCF Yield is the ratio of free cash flow per share to the current market price per share, expressed as a percentage:

FCF Yield = (Free Cash Flow per Share / Price per Share) — calculate it here × 100%

Alternatively, it can be calculated on an enterprise or company-wide basis as:

FCF Yield = Free Cash Flow / Market Capitalization

FCF yield tells investors how much free cash flow a company generates relative to its market value. A higher FCF yield suggests the stock may be undervalued or that the company generates ample cash relative to its valuation, which can support dividends.

1. Cash is King: Dividends are paid in cash, not earnings. A company with strong earnings but weak cash flow may struggle to sustain dividends.
2. Non-Cash Charges: Earnings include non-cash expenses like depreciation and amortization, which reduce net income but do not impact cash flow directly.
3. Accounting Manipulation: Earnings can be affected by accounting policies, one-time charges, or income recognition methods, potentially distorting the payout ratio.
4. Capital Expenditures: FCF accounts for reinvestment needs by deducting CapEx, providing a realistic view of cash available for dividends.
5. Predicting Dividend Growth: Companies with strong and growing FCF are better positioned to increase dividends consistently.

The FCF payout ratio measures the proportion of free cash flow paid out as dividends:

FCF Payout Ratio = (Dividends Paid / Free Cash Flow) × 100%

Dividends Paid: Total cash dividends paid to shareholders over a period.
Free Cash Flow: As defined earlier.

A healthy FCF payout ratio is critical to ensure dividends are sustainable even during economic downturns or temporary cash flow dips.

• Ideal Range: Generally, an FCF payout ratio below 60% is considered healthy. It indicates the company retains enough cash to fund operations, growth, and buffer against uncertainties.
• Too Low (<20%): May suggest the company is underpaying dividends and could increase payouts.
• Too High (>80%): Signals risk that dividends may be cut if cash flow declines.

• Focus on FCF yield and FCF payout ratio rather than earnings payout ratios to assess dividend safety.
• Look for companies with FCF payout ratios below 60% to ensure a margin of safety.
• Analyze trends in FCF and dividends over multiple years to identify sustainable and growing payouts. For a real-world example, see our Verizon FCF deep dive, which demonstrates a 62% FCF payout ratio with strong cash flow coverage.
• Consider the overall financial health, including cash reserves, debt levels, and capital expenditure needs.
• Use FCF yield as a valuation tool to identify potentially undervalued dividend stocks with strong cash flow generation.