The most important metric for investors seeking good dividend-paying stocks isn’t yield or even the number of years a company has paid or increased its dividend.

It’s free cash flow, or cash from operations less capital expenditures. “The cash flow is a key item,” says Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. Without it, he observes, a company can’t write that dividend check. And, Silverblatt notes wryly, “There’s no such thing as an operating dividend.”

Unlike “operating earnings,” from which management can exclude any number of unpalatable items, it’s much more difficult to massage the free cash flow numbers. The company either has the cash to pay a dividend, or it doesn’t.

BUYBACKS OVER DIVIDENDS

Just having good cash flow doesn’t ensure that a company will pay a dividend, of course. “A lot of cash-flow generating companies don’t pay much in dividends,” notes Jen Cole, founder of Cole Financial Consulting in Sandia Park, N.M. “They use their cash flow to buy back stock, or they use it to buy other companies.”

Stock buybacks are popular for a number of reasons: They often reduce the share count, resulting in higher earnings per share even when top-line growth stalls. Advocates of buybacks say that higher per-share earnings can drive up the stock price, benefitting holders. Buybacks also benefit management, whose compensation is often directly linked to per-share earnings growth. Many investors would prefer to see that free cash flow directed toward dividends, so that the actual owners of the company can determine if they want to reinvest in it.

'YOU NEVER KNOW'

Acquisitions are another alternative use for free cash flow, but the history of such deals is mixed. Berkshire Hathaway and Google both generate plenty of cash flow, but they buy other firms rather than paying out dividends. Nobody can compete with Warren Buffett’s record as a serial acquirer of top-notch companies. In the case of Google, some acquisitions have been profitable; for others, it’s too soon to tell.

That makes management’s attitude toward dividends almost as important as the company’s ability to pay them. And situations do change over time. Warren Buffett is 84, and though he has selected his successor, that person’s identity and approach to dividends remains a secret.

Says Silverblatt, “You never know if they’ll pay a dividend.”

Joseph Lisanti, a Financial Planning contributing writer in New York, is a former editor-in-chief of Standard & Poor’s weekly investment advisory newsletter, The Outlook.

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