If you want to generate income from your investment portfolio, you can easily spread your risk across a large group of stocks through mutual funds or exchange-traded funds, some of which in turn pay dividends monthly. But you might also want to hold individual stocks as part of a diversified income strategy.
Below is a screen designed to identify high-yielding dividend stocks whose payouts are expected to be well supported by cash flow over the next year.
This isn’t necessarily the best way to screen dividend stocks. A lot depends on your investment objectives. If high yields with a degree of safety appeal to you, this screen might be a good starting point. But here are other approaches to dividend stocks we have covered this year:
One way to estimate a dividend-paying company’s ability to maintain and hopefully raise its payout is to look at its estimated free cash flow yield.
Free cash flow (FCF) is remaining cash flow after capital expenditures. This money can be used to pay dividends, buy back shares (which can raise earnings and cash flow per share), fund acquisitions or organic expansion, or for other corporate purposes.
If we divide a company’s estimated FCF per share for the next 12 months by its current share price, we have its estimated FCF yield. If we compare the FCF yield to the current dividend yield, we may see “headroom” for cash to be deployed in ways that can benefit shareholders. If a stock with a 5% dividend yield has an estimated FCF yield of 7%, it appears to have headroom of 2%. That might be a good enough cushion depending on a company’s industry and prospects, but we took a more strict approach for the following stock screen.
We began the screen with the components of the S&P 1500 Composite Index XX:SP1500, which is made up of the S&P 500 SPX, the S&P MidCap 400 Index MID and the S&P Small Cap 600 Index SML. Then we narrowed the list as follows:
For most companies in the financial sector, especially banks and insurers, FCF information isn’t available. But in these heavily regulated industries, earnings per share can be a useful substitute to make similar headroom estimates. We also used EPS for real-estate-investment trusts that engage mainly in mortgage lending.
