Latest / Dividend Investing with Fexingo: Income Stocks, Yield, and Long-Term Cash Flow Portfolios / Free Cash Flow Coverage Is the Dividend Metric That Matters Now
Transcript
- Lucas: When I look at dividend stocks right now, I'm not just looking at the yield or the payout ratio. The metric I'm watching most closely is free cash flow coverage. Luna: You mean how much of the dividend is actually backed by cash the company generates—not just reported earnings? Lucas: Exactly. Earnings can include non-cash items like depreciation or amortization. But free cash flow is the cash left after all capital expenditures—money that can actually be paid out, buy back stock, or pay down debt. With the 10-year Treasury now yielding 4.71%, investors are demanding more from their dividends, so safety is paramount. Luna: Right. And if a company is spending heavily on something like AI data centers, that could eat into free cash flow fast. Lucas: That's exactly the risk Moody's flagged this week—'unprecedented' AI spending threatening credit quality at Amazon, Meta, Alphabet. Those companies are not traditional dividend payers, but it's a warning sign for any company with heavy capex. If a firm's free cash flow coverage ratio drops below 1.0, it's paying out more in dividends than it generates in cash. That's a red flag. Luna: So how do we find the ones with solid coverage? Can you give a real example? Lucas: Sure. Take Procter & Gamble—stock at about $147. It yields around 2.6% on a $3.80 annual dividend. P&G's free cash flow coverage typically runs around 1.3 to 1.4 times, meaning it generates 30 to 40 percent more cash than it needs for the dividend. That's a wide cushion. Luna: And they don't have massive capex requirements—they're not building factories or data centers every year. Lucas: Exactly. Their capital spending is relatively stable. Now contrast that with a utility or a telecom—Verizon, for example. Verizon yields over 5.7% at $46, but its free cash flow coverage has been tight in recent years, often below 1.1 times, and sometimes dipping under 1.0. That higher yield comes with higher risk. Luna: So the lesson is: don't just screen for high yield. Look at free cash flow yield—the ratio of free cash flow per share to stock price—and compare it to the dividend yield. Lucas: Right. If the free cash flow yield is higher than the dividend yield, you have coverage. Ideally you want a healthy margin. In today's environment, with rates flat at 3.63% and the 2-year at 4.37%, the steepening curve is pressuring weaker companies. The 10-year minus 2-year spread is 36 basis points and widening. Luna: That means the market expects higher long-term rates, which can increase borrowing costs for companies that need to refinance debt. That directly squeezes free cash flow. Lucas: Correct. So a company with a 10-year bond yield of, say, 5.5% that has to roll over debt at those rates will see its interest expense rise, reducing cash available for dividends. That's why I'm focusing on firms with low leverage and strong free cash flow generation. Luna: And dividend ETFs? How do they screen for coverage? Lucas: Most dividend ETFs—like VYM at $162.23 or SCHD at $33.29—use dividend yield or dividend growth screens, but they rarely mandate a free cash flow coverage threshold. So you can own an ETF that holds a company that later cuts its dividend because of weak cash flow. Luna: So the burden is on us as individual investors to do the extra homework. Lucas: Yeah, but it's not that hard. You can pull free cash flow from the cash flow statement in any annual or quarterly report. I like to look at the trailing twelve months of free cash flow and divide it by total dividends paid. If that number is above 1.2, I feel comfortable. Luna: What about Coca-Cola? It's at $82.25—how does its coverage look? Lucas: Coca-Cola is another solid example. Its payout ratio from free cash flow has historically been around 70 to 75 percent, so coverage around 1.3 to 1.4. Yield is only about 2.2%, but you sleep well at night. The trade-off is lower current income for higher reliability. Luna: And in a world where the 30-year Treasury is above 5%—it's at 5.17%—some investors might say 'why take equity risk for a 2.2% yield?' Lucas: That's the big debate. But dividend growth matters. A 2.2% yield that grows at 6% annually will double your yield on cost in about 12 years. A 5% bond doesn't grow. Plus, with the Fed likely on hold—the effective fed funds rate has been flat at 3.63% since June—dividend stocks with pricing power can still produce real returns. Luna: You mentioned capital expenditures earlier. The AI spending headline is a perfect example of how a company's strategic choices can impact dividend safety. If a firm decides to spend $100 billion on data centers, its free cash flow dries up. Lucas: Exactly. And that's why when we talk about dividend investing, we have to look beyond the income statement to the cash flow statement. If you can't see the cash, the dividend is on borrowed time. Luna: I want to pause here because this conversation is exactly why we keep this show ad-free—to bring you honest, unfiltered analysis without any sponsor pushing products. If you find value in these episodes, the best way to support that independence is through listeners like you. You can buy us a coffee at buy me a coffee dot com slash fexingo. That simple act keeps us free of commercial pressure and lets us keep drilling into what actually matters. Lucas: Yeah, it makes a bigger difference than you might think. Every contribution helps us dedicate more time to research like today's topic. Luna: Alright, back to free cash flow coverage. So let's say I'm screening for stocks. What's a quick practical tip? Lucas: One shortcut is to look at the free cash flow yield. If a stock's free cash flow yield is higher than its dividend yield, then the dividend is covered. For example, a stock with a 3% dividend yield and a 5% free cash flow yield has plenty of room. If the free cash flow yield is only 2%, the dividend might be unsustainable. Luna: And you can find that data on many financial websites—just look up the company's free cash flow per share over the last twelve months and divide by the current price. Lucas: Right. And don't forget to compare it to the payout ratio from earnings. A low payout ratio from earnings but poor free cash flow coverage can still be risky—because earnings can be manipulated or include large non-cash gains. Luna: Overall, the takeaway is that in a high-rate environment, free cash flow coverage is your best friend for dividend safety. Lucas: I'd say that's the number one screen for anyone building a dividend portfolio right now. It doesn't matter if the yield is 4% if the cash isn't there. Look at the cash flow statement first, then the yield. Luna: Thanks, Lucas. That's a great framework to carry into our research this quarter. Lucas: Glad to help. That's it for Episode 131—we'll be back soon with more dividend-focused insights.