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Building Cash Flow Nirvana Through Dividend Stocks

Adam Brownlee, The Motley Fool

The path to financial independence is difficult. Financial independence is a goal that nearly everyone strives toward, but it can be difficult to know the right steps to take to get there. One of the best ways to reach financial independence is to cultivate a stream of investment income. Dividend-paying stocks provide just this sort of income stream.

However, a dividend alone isn't worth all that much. In order to pay the bills, we need companies that deliver reliable dividends. If we look for companies with certain common characteristics, such as a consistent track record of dividend raises, a low payout ratio, and plenty of cash flow, though, we should be able to find companies that deliver reliable dividend income. Let's take a look at each of these measures in turn.  

Picture of McDonald's Big Mac, Fries, Coke, iPhone

Source: McDonald's

Consistent history of dividend raises

When building a dividend portfolio, investors often look for companies that have consistently raised their dividends over time. Common sense tells you why making more and more money every year on the same initial investment is a good thing. In addition, companies that continue to raise their dividends over time likely have consistent earnings growth, which every investor likes to see.

Thankfully, we don't have to look too far to find companies that check these boxes. McDonald's (NYSE: MCD), franchisor of one of the world's largest hamburger chains, has raised its dividend for 43 straight years, with its payout increasing 1,000% over the same time period. This was driven by consistent earnings increases. McDonald's earnings have grown at a 7.21% CAGR over the last ten years.   As a result of these consistently increasing dividends, investors who purchased the stock in the high 20's back in 2002 now enjoy an effective yield of 17.5% on their investment . If a dividend investor is able to string together just a few of these dividend increasing companies over a lifetime, the path to financial independence is well within his or her grasp.

Low payout ratio

Another hallmark of a strong dividend investment is the ability for a company to pay its dividends while also being able to reinvest back into the business. A company that has to cut its payment to keep the lights on is of little use to an investor seeking reliable cash flow. Smart investors will therefore hone in on investments that pay out a low percentage of their net earnings as dividends.

One metric investors look at to identify investments with safe dividends is the payout ratio. This measure is simply the percentage of earnings that the company pays out in dividends.  Stocks with plenty of payout breadth have room to reinvest in the company, another sign of a winning investment. 

It is not hard to find a company that checks this box. The Home Depot (NYSE: HD), the huge retailer of building materials and home project supplies has a payout ratio of 42%.  This means that the company is only paying out 42 cents in dividends for every dollar that it earns.

With almost 60 cents left over to spend elsewhere in the business, Home Depot has plenty of wiggle room to keep paying its dividend and reinvest back in the company at the same time. This means that when high ROIC opportunities present themselves, Home Depot can act without hesitation.

In the past, this powder was put to good use, as returns on invested capital for Home Depot have averaged just over 20% for the last 10 years.   These investments have been rewarding for shareholders, with Home Depot's stock up over 700% in the last 10 years.  This winning combination of a low payout ratio and strong returns gives investors a solid foundation on which to build a dividend portfolio and reach financial independence. 

Robust free cash flow 

Finally, smart investors will want to know if an investment has plenty of cash to cover its dividend when building a dividend portfolio. Investments that provide reliable dividends not only have wiggle room in the profits, but they also have generous amounts of cash flow to cover payouts. To measure this, we look at the free cash flow of the company. Think of cash flow as the lifeblood of a business. It is used to pay the bills, settle debts and most importantly in our case, pay the dividends. Free cash flow takes this a step further by subtracting out capital expenditures, those very real expenses such as building and equipment costs that are ignored in earnings. For our dividend portfolio, we want to add stocks that generate large amounts of cash flow to cover our dividend.

In order to check this box, we turn to southern cooking. Cracker Barrel (NASDAQ: CBRL), operator of old time general store-themed restaurant and retail establishments, saw free cash flow of almost $178 million last year which came to $8.61 per share. By comparison, the company paid out $4.85 per share in dividends which means that Cracker Barrel could cover its dividend by almost two times using free cash flow.  For investors who want a stable dividend, this is great news as it indicates the company had plenty of cash flow to make the dividend payment. Also, this cash flow has grown at a 17.33% CAGR over the last ten years and as a percent of sales, grew by nearly 2%. Growth like this is a positive sign for investors as it tells us that the company can keep up with dividend increases.  If a dividend investor can hunt down these cash flow generators with plenty of coverage and growth, it makes for smooth sailing to financial independence. 

Final analysis

To reach financial independence, investors need a reliable stream of income. One source of this cash flow is dividend paying stocks. However, to make sure this stream is reliable, smart investors will first check for a long record of raises, sustainable payouts, and healthy cash flow before committing capital. If these boxes can be checked off then financial independence could be right around the corner.  

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Adam Brownlee owns shares of Coca-Cola. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.