It's not that most companies have done anything wrong when preparing their Statement of Earnings, but under Generally Accepted Accounting Principles (GAAP) a lot of the entries have nothing to do with today's operations. Given this, I generally avoid most earnings related metrics (e.g. EBIT, EBITDA, payout ratio, etc.) Instead I focus on cash-based metrics, such as these:
Free Cash Flow - This has many definitions, but the one I use is operating cash flow less capital expenditures. Capital expenditures are deducted since you can't run a business for any period of time without expending some level of capital. These two numbers are easily located on the Statement of Cash Flows. This is the best snapshot of what cash the business has generated from "normal" operations and is available for dividends, debt, acquisitions and purchases of treasury stock.
Cash Flow Per Diluted Share - GAAP Earnings Per Share (EPS) has the same short-comings as GAAP earnings. When looking at EPS numbers I prefer a cash-based number. Cash Flow Per Diluted Share is calculated by taking the Free Cash Flow from above and dividing it by diluted shares outstanding (available on the Statement of Earnings).
Cash Payout Ratio - Dividend investors love payout ratios (dividends per share/EPS). Given my concerns with GAAP earnings and EPS, I once again prefer a cash-based version. The Cash Payout Ratio is calculated by dividing dividends per share by Cash Flow Per Diluted Share. Care should be taken when interpreting this ratio. For example, sometimes a high ratio with low debt is better than a low ratio with high debt.
Debt to Total Capital - Total capital is the sum of debt plus shareholders equity (both available on the Balance Sheet - don't forget the debt classified as short-term). Businesses are generally funded in one of two ways, equity or debt. Normally debt is more expensive than equity, while additional equity can potentially dilute current shareholders over the long-term. I consider a good balance to be 35% debt and 65% equity. I see the upper end for debt as 50% and then there needs to be a good reason for being there.
Cash Return on Capital Employed - This is simply Free Cash Flow divided by Total Capital (both are defined above). Again, I prefer using a cash number in the numerator. A lot of investors look at return on assets and return on equity. Each are flawed beyond their GAAP numerator. Return on assets ignores the liabilities side of the balance sheet, while return on equity ignores the debt component of capital.
Using 2008 data from Morningstar, let's run the numbers on a couple of companies and see what we find:Genuine Parts Co. (GPC)
Free Cash Flow: $425.3 million
Cash Flow Per Diluted Share: $2.63 (425.3/162)
Cash Payout Ratio: 59% ($1.56/$2.63)
Debt to Total Capital: 18% (500/(500+2,324.3))
Cash Return on Capital Employed: 15% ($425.3/(500+2,324.3))General Electric Company (GE)
Based on the above, GE started out strong with a low cash payout ratio, while GPC's appeared to be on the high side. However, GPC has very little debt so it can afford to pay a richer dividend unlike GE. GPC is doing a much better job than GE in earning a return on its invested capital. Having low debt and generating a 15% return in a year like 2008, will turn some heads. As with any metric, these should not be considered in isolation. Also, you should look at multiple years, consider projections and review the scheduled debt payments in the footnotes.
Free Cash Flow: $32,591.0
Cash Flow Per Diluted Share: $3.23 (32,591.0
Cash Payout Ratio: 38% ($1.24/$3.23)
Debt to Total Capital: 83% (523,762/(523,762+104,665)
Cash Return on Capital Employed: 5% ($32,591.0/(523,762+104,665))
To succeed as a dividend investor, you must find companies that can sustain and grow dividends by focusing on their ability to generate cash. You can fake earnings, but you can't fake cash.
Full Disclosure: No position in any of the aforementioned securities.
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Good summary