With companies slashing dividends right and left (Dividend Slashers), I have started using a new metric to navigate this market: the Dividend Coverage Ratio. I have lived through the painful Pfizer and Bank of America dividend cuts over the last year, so now I am seeking a significantly wider margin of safety as a dividend investor. Traditionally, the Dividend Coverage Ratio is calculated by dividing the earnings per share (EPS) by the dividend per share. EPS is net income based, however, and this number has depreciation subtracted, as well as other adjustments that make it, well, subjective. Therefore, I have started using a "free cash flow based" dividend coverage ratio, calculated as follows:
Dividend Coverage = Total Free Cash Flow ÷ Total Dividends Paid
Free cash flow is operating cash flow less capital expenditures, which the company must make to stay in business. Calculating Dividend Coverage this way, can be very revealing and lets you know how many times over the company can pay its dividends in cash. The higher the ratio the better; if the ratio is less than 1.0, it could signal trouble. I am applying this ratio to the most recent quarter, when I analyze a company, and to the past year. Cash flow for most NYSE and NASDAQ companies can be found at Yahoo Finance, TD Ameritrade as well as other broker sites that provide research.
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