Here is how it works. If we have a dividends to free cash flow ratio of 30%, it implies that for every $1 of free cash flow the company generates, it only pays out 30 cents as dividends.
Why we need to look at this metric is because other than finding stocks that give high dividends, we also want the companies to have the ability to distribute stable and consistent dividends, in other words, the sustainability of the dividends distribution over the long term.
The rationale behind this metric is quite similar to that of another ratio called the dividend payout ratio, except we are now working with cash flow instead of net income to give us a better idea of the sustainability of the dividends distribution.
Net income is an accounting figure so there are some items that are non-cash but they are part of deriving the net income figure for a company. To explain in slightly more layman’s terms, it means that certain transactions of recording revenue or of recording expenses do not involve the inflow or outflow of cash.
In addition, the net income figure is generally more easily subjected to accounting manipulations due to the involvement of judgment and estimates. As a result, a company could have earned for example, $1 million net income but it only has generated $700k increase of cash for the year. Hence, using free cash flow give investors a better idea on whether the company has sufficient cash to pay out its dividends on time and whether the dividends distributed are sustainable.
An overly high dividends to free cash flow ratio may be unsustainable over the long run as the company would still need to use cash for its business purposes. If a company has a dividend to free cash flow ratio of more than 1, that is not ideal as it implies that the company is paying out more cash as dividends than how much it is growing. Never go for stocks that give you high dividends in just only one or two years at the expense of the sustainability of the dividend distribution over the long run.
Next up, stay tuned for our upcoming blog post as we will be sharing some of the untold truths of dividend investing!
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Hi, thanks for sharing. In relation to Dividends to Free Cash Flow, what would be a healthy ratio to ascertain if the company has the ability to distribute stable and consistent dividends?
Hey Yong, a general rule of thumb is that the ratio should be less than 1 which means that the FCF generated for the year can cover the dividends to be paid