When it comes to dividends, quality is more important than quantity.
When scanning the market for passive income plays, it's easy to get enamored of a stock with a high yield. But yield is arguably one of the most overrated qualities of a dividend-paying company.
Here are five metrics that can help you evaluate a dividend stock beyond its yield.
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1. Free cash flow yield
Free cash flow (FCF) yield is one of my favorite metrics for any company, not just dividend stocks. Just as dividend yield is simply the dividend per share divided by the share price, FCF yield is the FCF per share divided by the share price. It basically tells you the hypothetical yield of a stock if it distributed all of its FCF to shareholders.
Mega-cap tech-oriented companies like Apple (AAPL -1.10%), Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), and Meta Platforms (NASDAQ: META) are highly efficient businesses that generate a ton of FCF.
AAPL Free Cash Flow Yield data by YCharts
In fact, all three companies could have dividend yields over 3% if they devoted all their FCF to dividends, but they would rather buy back stock and reinvest in the business (a strategy that has historically accelerated growth and benefited shareholders).
If a company's FCF yield exceeds its dividend yield, that's a sign that it can more than support its dividend with FCF, instead of relying on reserve cash or debt.
2. Payout ratio
Payout ratio is one of the most common metrics for determining whether a dividend is affordable. It's simply the dividend per share divided by the earnings per share. If the ratio is less than 1, then earnings are higher than the dividend.
Generally speaking, a 75% or lower payout ratio would be good for a financially strong company, and 50% or lower would be good for a cyclical or more volatile company that should retain more of its earnings.
The best way to view the payout ratio is with other metrics, like FCF yield. Sometimes, earnings per share can be skewed by one-time windfalls or impairment charges that give a company an artificially high or low payout ratio.
3. Capital return yield
A capital return program consists of dividend payments and/or stock repurchases. Capital return yield is a term I came up with to better evaluate the full scale of a company's capital return program instead of just looking at dividends. It's simply the dividend expense plus the stock repurchase expense divided by a company's market cap. Let's go back to Apple as an example.
Apple pays a dividend, but it prefers to reward shareholders with buybacks. Warren Buffett-led Berkshire Hathaway (BRK.A 0.19%) (BRK.B 0.15%) owns 5.9% of Apple. Buffett has praised Apple's buyback program over the years, since it allows Berkshire to gradually own a larger percentage of the company without the need to buy back more shares. Berkshire prefers to buy back its stock and doesn't pay a dividend. And a core reason why it has held American Express and Coca-Cola for over 30 years is because both companies pay dividends and buy back stock.
Between second-quarter fiscal 2023 and first-quarter fiscal 2024, Apple paid $15.1 billion in dividends and $78.2 billion in buybacks.https://ycharts.com/charts/fund_chart_creator/fool/#/?annotations=&annualizedReturns=false&calcs=id:price,include:false,,id:stock_buyback,include:false,,id:stock_buybacks_ttm,include:true,,id:dividend_ttm,include:false,,id:total_stock_dividends_paid_ttm,include:true&correlations=&dateSelection=range&displayDateRange=&displayTicker=false&endDate=&format=real&legendOnChart=false¬e=&partner=fool_720"eLegend=false&recessions=false&scaleType=linear&securities=id:AAPL,include:true,type:security,,&securityGroup=&securitylistName=&securitylistSecurityId=&source=false&splitType=single&startDate=&title=&units=false&useEstimates=false&zoom=1&chartId=&chartType=&customGrowthAmount=&dataInLegend=value&lineAnnotations=&nameInLegend=name_and_ticker&useCustomColors=false&hideValueFlags=false Apple only has a 0.6% dividend yield. But with a market cap of $2.67 trillion and a capital return program of $93.3 billion, its capital return yield is 3.5%. So, if Apple reallocated stock buyback funds toward dividends, the stock would yield 3.5%.
There are plenty of companies with low yields but massive capital return programs. Another example is Deere (DE 0.93%), which spent $1.47 billion on dividends over the last 12 months but a whopping $7.29 billion on buybacks.Granted, the buybacks are particularly high because the cyclical company is generating outsized earnings. Still, Deere has a 1.5% dividend yield, but with a market cap of $110.2 billion, its capital return yield is much higher at 8%.
There are also companies with high yields that do few to no buybacks. A good example is industrial conglomerate 3M (MMM 0.24%), which has a6.1% yield but a negligible buyback program because it has been facing earnings declines. To make matters worse, 3M is about to reset and likely cut its dividend after completing its spin-off of its former healthcare business. So not only is the capital return yield essentially the same as the dividend yield due to a lack of buybacks, the dividend yield is also misleading due to the new direction of the business.
4. Consecutive years of dividend increases
A company's ability to raise its dividend year after year is usually due to growing earnings and financial stability throughout the business cycle. A track record of consecutive dividend raises tells investors they can count on the company to raise the payout no matter what the economy is doing.
Companies that have paid and raised their dividends for at least 50 consecutive years are known as Dividend Kings. Procter & Gamble (PG 0.63%) is a good example of a company that doesn't have a high yield but is about as reliable a dividend payer as you can find. In April, P&G raised its dividend for the 68th consecutive year. The business model is resilient even in a recession, since it focuses on goods people need no matter what the economy is doing. P&G also tends to buy back a good amount of its own stock, giving it a capital return yield of 3.3%, compared to a dividend yield of 2.5%.
P&G showcases why a quality dividend and capital return program is far more important than a high yield.
5. Total return
When it comes to dividend investing, the total return is far more important than the capital gains in the stock. Take Target (TGT -1.68%), for example.
Like P&G, Target has paid and raised its dividend for over 50 consecutive years -- making it a Dividend King. Over the last decade, Target stock has gained 156% -- lower than 169% for the S&P 500. But Target's total return, which factors in dividends, is 236%, higher than the 221% total return of the S&P 500.
Target's dividends are a core part of the investment thesis, so it's important to look at total return rather than just the price of the stock. In Target's case, the bulk of the gains have still come from the stock price going up. But this isn't true with all companies.
Kinder Morgan (KMI 0.36%) is a pipeline and energy infrastructure giant with a sizable 6.3% yield. But the stock is down 6% over the last five years, while the total return is 28%. In this vein, Kinder Morgan has been a reliable way to supplement income in retirement and collect a high amount of passive income, but the value of the company hasn't gone up.
Understanding total return and whether a company's dividend is likely going to be the primary or secondary means of return can be helpful when choosing which dividend stocks to buy.
A dividend is only as strong as the business paying it
Dividend yield tells you how much passive income you can generate from a stock right now. But it doesn't tell you the quality and affordability of that payout, whether the business is in good shape, the extent of the capital return program beyond the dividend, or whether the business has a track record for delivering on promises to investors.
When scanning the market for passive income plays, investors would do well to consider FCF yield, payout ratio, capital return yield, consecutive years of dividend increases, and total return.
Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. American Express is an advertising partner of The Ascent, a Motley Fool company. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Apple, Berkshire Hathaway, Kinder Morgan, Meta Platforms, and Target. The Motley Fool recommends 3M and Deere & Company. The Motley Fool has a disclosure policy.
