One of the most common mistakes made by dividend investors is relying solely on yield and payout ratio to determine the safety of the dividend. A high dividend yield and payout ratio might signify that the dividend is unsustainable and that a dividend cut is inevitable.
Not so fast. A company’s payout ratio is typically measured against a company’s earnings. Earnings often include many one-time and non-cash items that have no bearing on the company’s ability to pay a dividend. Likewise, a high yield doesn’t mean anything without context.
This is why I also look at a company’s dividend in relation to cash flow. This provides investors with a more accurate picture on the safety of the dividend. With that in mind, here are three stocks with above-average yields whose dividend are well covered by cash flow.
A top industrial stock
Aecon Group (TSX:ARE) is one of my favourite in the space. After the failed takeover attempt by China Construction, the company has flown under the radar. This is a company that is firing on all cylinders.
In 2018, the company achieved record revenue, up 16% over the full year 2017. It booked $5.8 billion in new contracts, a 107% increase over the $2.8 billion in booked in 2017. Now that the takeover overhang is behind it, the company is well positioned to move forward.
The company yields 3.27% and its dividend as a percentage of free cash flow is only 11%. It also raised dividends by 14.5% along with fourth-quarter results.
A hidden technology stock
Pason Systems (TSX:PSI) is a technology company buried in the oil and gas industry. Year to date, Pason’s stock is up 9% and has returned approximately 14% in the past year.
Pason currently yields 3.65%; however, it has a payout ratio near 95%. Is this reason for concern? Not at all. The company has no debt, and its dividend accounts for only 57% of cash flow.
It is also important to note that this is a company expected to grow earnings by double digits over the next couple of years.
An unloved consumer cyclical
Down 14% year to date, Transcontinental (TSX:TCL.A) has struggled over the past couple of years. As a result, the yield has jumped and it is now at levels not seen in almost a decade (5.27%).
Is the dividend safe? It sure looks that way. The payout ratio as a percentage of earnings is a reasonable 40% and it drops to 21% when compared to operational cash flow.
The company certainly has its challenges, but it is still expected to achieve low single-digit earnings growth over the next few years. Transcontinental is a Canadian Dividend Aristocrat with a 17-year streak of raising dividends. Even with slowing earnings growth, it has ample flexibility to grow its dividend.
