Free Cash Flow and Dividends:
How A Focus On Yield Can Help Investors
Provide for Today and Prepare for Tomorrow
A White Paper by Manning & Napier
www.manning-napier.com
Unless otherwise noted, all figures are based in USD.
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Free Cash Flow and Dividends:
How A Focus on Yield Can Help Investors Provide For Today and Prepare For Tomorrow | A White Paper by Manning & Napier
A Fundamental Investor Problem
Among the multitude of risks that investors face, two stand
out as being inherently interconnected; so much so that to
offset one, investors must expose themselves to the other.
These twin risks are (1) meeting cash flow requirements
today and (2) providing adequate capital growth for the
future. To meet cash requirements today, investors will
traditionally allocate to bond securities which produce
income through their coupon payments and often provide
significant downside protection for those investors who sell
assets to raise cash. Future capital growth can generally be
achieved by allocating to stock securities, which have the
potential to preserve the purchasing power of your assets
by providing a long-term return exceeding inflation.
Take, for example, an institutional investment fund such
as a defined benefit plan or an endowment. These funds
are often committed to financing liabilities on a regular
basis (participant liabilities in the case of a retirement plan
or charitable liabilities in the case of an endowment). A
significant amount of current cash flow is needed to meet
their fiduciary obligations to their current beneficiaries;
therefore income production and downside protection are
important risk priorities. However, these funds typically also
have future obligations and therefore need to ensure their
long-term viability through capital growth.
A similar situation exists for retired individual investors.
Retirees, like institutional funds, have a need for current
cash flow coming from their investment portfolio as they rely
on these assets to provide for living expenses. In addition,
retirees must often plan for the long-term by placing
emphasis on capital growth to ensure that their portfolio can
last throughout their entire retirement.
The common thread, whether you are an institutional fund
or an individual in retirement, is that investors often need
to balance current cash flow needs with future capital
growth. Manning & Napier believes that, in addition to an
asset allocation that includes bonds (for income production
and downside protection) and stocks (for capital growth),
investors may wish to consider an allocation to high free
cash flow yielding, high dividend yielding stocks.
This paper will explore (1) why focusing on these two characteristics can help solve the investor problem listed above
and (2) how stocks that have demonstrated high cash flow
yields and high dividend yields have performed over the last
two decades. What we will see is that a portfolio constructed
of both high free cash flow yielding and high dividend
yielding stocks may provide an attractive complement to a
traditional stock and bond allocation.
Free Cash Flow Yield
Free cash flow is the amount of cash that a company generates through its operations that remains after paying out the
expenses for keeping the company in business. It can be
calculated as:
Cash Flow from Operations – Capital Expenditures =
Free Cash Flow
By dividing a company’s fiscal year free cash flow per share
by its current stock price, this number is transformed into
a yield statistic, becoming a valuation measure with some
particularly attractive characteristics.
Free Cash Flow Is Less Susceptible To
Accounting Manipulations
While earnings figures on a company’s income statement can often be distorted through the use of accruals,
depreciation and by capitalizing expenditures, free cash
flow generally avoids these pitfalls as it is very difficult for
companies to hide how much cash they take in for a given
period. The bankruptcy of the Enron Corporation may be the
most egregious example of free cash flow raising red flags
about a company’s financial health. In the 15 quarters prior
to their bankruptcy in 2001, Enron posted 14 quarters with
positive earnings per share, but only 5 quarters with positive
free cash flow per share.
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Free Cash Flow and Dividends:
How A Focus on Yield Can Help Investors Provide For Today and Prepare For Tomorrow | A White Paper by Manning & Napier
Generating Free Cash Flow Can Give
Companies a Funding Advantage
Companies have many choices of what to do with the free
cash flow that they generate. Common decisions include
making acquisitions, investing in internal projects, paying
down debt, repurchasing stock, or paying out dividends.
Of course the underlying benefit of free cash flow is
that it gives a company the funding to grow and reward
shareholders without requiring new debt or equity to be
obtained. Out of all the funding sources in a company’s
arsenal, free cash flow is often considered the most
desirable for current shareholders as it does not share the
same destabilizing effects as issuing too much debt or the
dilutive effects of issuing additional equity.
By Incorporating a Pricing Element,
Free Cash Flow Yield Has Generated
Attractive Total Returns
As free cash flow yield is a measure of price relative to
a fundamental indication of value, it may help identify
attractive companies for investment. To test this theory,
Figure 1 demonstrates what happens when we divide the
Russell 1000 Index1 into quartiles based on the free cash
flow yield of each company (first quartile meaning highest
Figure 1: Free Cash Flow Yield Quartiles
Annualized Total Return (01/01/1990-12/31/2011)
free cash flow yield). Since 1990, the highest quartile of free
cash flow yielding companies (rebalanced annually) has
generated total returns greater than any other quartile and
the equal weighted holdings of the Russell 1000 Index.
There are Downsides to Focusing Solely
on Free Cash Flow Yield That Investors
Should be Aware of
While a company does have the flexibility to seek out
high return ventures with the cash they have on hand,
doing so creates uncertainty, as future events may not
unfold as expected. There is the possibility, therefore,
that company management chooses not to return capital
to the owners of a business but instead squander it in a
value destroying endeavor.
As a result of this risk, investors may perceive even
high free cash flow yielding companies as more risky
when it comes to the uncertainty of recognizing profits,
especially compared to a company that returns capital
to shareholders via dividends. Although yield statistics
incorporate price and mitigate some downside risk
compared to the overall market, dividend yield has shown
itself to be a better indicator of downside risk, as shown
in Figure 2.
Figure 2: Free Cash Flow Yield and
Dividend Yield Quartiles
Downside Capture Ratio (01/01/1990-12/31/2011)
14.28%
109.99%
10.67%
95.03%
10.48%
79.48%
9.15%
6.49%
1st Quartile
(Highest Free
Cash Flow
Yield)
2nd Quartile
Source: FactSet
Analysis: Manning & Napier
3rd Quartile
4th Quartile
(Lowest Free
Cash Flow
Yield)
Russell 1000
Holdings Equal
Weighted
1st Quartile
(Highest
Dividend Yield)
1st Quartile
(Highest Free
Cash Flow Yield)
Russell 1000
Holdings Equal
Weighted
Relative to the Russell 1000 Index
Source: FactSet
Analysis: Manning & Napier
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Free Cash Flow and Dividends:
How A Focus on Yield Can Help Investors Provide For Today and Prepare For Tomorrow | A White Paper by Manning & Napier
Dividend Yield
Dividends represent the portion of a company’s earnings
that are paid out to shareholders, often at regular intervals
according to a stated policy. Each company’s method for
choosing if and when to pay out a dividend will generally
depend on some sort of combination of earnings, market
environment, growth opportunities, and historic tradition.
Dividend yield is often calculated by adding the dividends
per share that a company has paid over the past twelve
months, and dividing that by the current price of the
company’s stock. In this way, dividend yield is a type of
valuation indicator, because it tells investors the price
they are paying per dollar of dividends. As the following
examples illustrate, investors may be able to benefit by
using dividend yield to select stocks.
Figure 3: Dividends Comprise Almost Half of
the Annualized Total Return of the S&P 500
from 1926 to 2011
Dividend Yield
42.67%
Capital Appreciation
57.33%
Source: Ibbotson Associates
Analysis: Manning & Napier
Dividends Have Historically Provided a
Significant Portion of Total Return
Despite fluctuating payout ratios and various laws that have
affected the treatment and taxes of dividends, dividends
have comprised a significant portion of the overall total
return of the stock market. Figure 3 shows what percentage
of the S&P 500 Index’s2 total return dividends have
comprised since 1926.
Companies that pay out dividends may also be associated
with higher total returns over the long-term. For example,
as Figure 4 demonstrates, over the 1972 to 2011 period,
dividend paying companies have outperformed non-dividend
paying companies by approximately 7.2% per year.
Figure 4: Annualized Returns of S&P 500
Companies from 1972 to 2011
Based on Whether They Ever Paid a Dividend or Not
8.61%
1.35%
Dividend Payers
Non-Dividend Payers
Source: Ned Davis Research, Inc.
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Free Cash Flow and Dividends:
How A Focus on Yield Can Help Investors Provide For Today and Prepare For Tomorrow | A White Paper by Manning & Napier
Higher Dividend Yields Have Generated
Superior Downside Protection
Figure 5: Dividend Yield Quartiles
Downside Capture Ratio (01/01/1990-12/31/2011)
A company that returns its cash to investors through a
dividend may be perceived by investors as less risky. The
dividend component of a stock’s total return (i.e., dividends
plus capital appreciation) can serve as important ballast
during periods of falling stock prices.
By dividing the Russell 1000 Index into quartiles based on
dividend yield (first quartile meaning higher dividend yield),
Figure 5 demonstrates that increased downside protection
is associated with higher dividend yields since 1990.
Obviously, higher dividend yielding companies also
provide a larger source of current income for investors.
Figure 6 illustrates the average dividend yield for each
dividend yield quartile over the period in question. This
income can be an excellent source of cash for institutional
funds and retired investors who need to meet current
spending demands.
Taken by Itself, Dividend Yield May
Also Have Some Limitations
As a stock picking factor, dividend yield has demonstrated
many beneficial aspects. However, there may be limitations
to consider:
• The reason why the dividend yield for some companies is high may be because their stock price has
fallen due to company specific shortcomings or risks.
137.12%
93.91%
79.48%
1st Quartile
(Highest
Dividend Yield)
2nd Quartile
3rd Quartile
4th Quartile
Russell 1000
(Lowest
Holdings Equal
Dividend Yield)
Weighted
Relative to the Russell 1000 Index
Source: FactSet
Analysis: Manning & Napier
Figure 6: Dividend Yield Quartiles
Average Dividend Yield (01/01/1990-12/31/2011)
4.12%
• By itself, dividend yield does not consider a company’s
ability to continue to pay out a dividend. While a
majority of dividend paying companies may be on
sound financial footing, history has given us many
examples of companies with high dividend yields right
before they were forced to cut dividend payments in
the face of deteriorating market conditions.
A company that has historically paid out dividends may be
attractive, but one that can continue to pay out and possibly
even grow their level of dividend payment is better. However,
by itself, dividend yield does not consider the underlying
growth potential of a company’s operations and therefore,
on a total return basis, may fail to achieve the level of overall
capital growth that some long-term investors are seeking.
109.99%
106.91%
1.93%
1.25%
0.77%
0.00%
1st Quartile
(Highest
Dividend Yield)
2nd Quartile
3rd Quartile
4th Quartile
Russell 1000
(Lowest
Holdings Equal
Dividend Yield)
Weighted
Source: FactSet
Analysis: Manning & Napier
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Free Cash Flow and Dividends:
How A Focus on Yield Can Help Investors Provide For Today and Prepare For Tomorrow | A White Paper by Manning & Napier
Figure 7 illustrates the total return of the highest quartile of
dividend yield compared to the highest quartile of free cash
flow yield and the equal weighted holdings of the Russell
1000 Index. High free cash flow yielding companies have
historically provided more long-term capital growth.
Figure 8: Free Cash Flow Yield and
Dividend Yield Quartiles
Annualized Total Return (01/01/1990-12/31/2011)
14.82%
14.28%
Figure 7: Free Cash Flow Yield and
Dividend Yield Quartiles
12.36%
10.48%
Annualized Total Return (01/01/1990-12/31/2011)
14.28%
12.36%
10.48%
1st Quartile
(Highest
Dividend Yield)
1st Quartile
(Highest Free
Cash Flow Yield)
Russell 1000
Holdings Equal
Weighted
Source: FactSet
Analysis: Manning & Napier
1st Quartile
(Highest Free
Cash Flow
Yield and
Dividend Yield)
1st Quartile
(Highest
Dividend Yield)
1st Quartile
(Highest Free
Cash Flow
Yield)
Russell 1000
Holdings Equal
Weighted
Source: FactSet
Analysis: Manning & Napier
Using Dividend Yield and Free Cash Flow
Yield Together: A Synergistic Combination
Figure 9: Free Cash Flow Yield and
Dividend Yield Quartiles
Alone, dividend yield and free cash flow yield have each
shown to be effective factors when screening for attractive
long-term investments. High free cash flow yield tends to
identify companies that have experienced higher rates of
total return, while dividend yield has identified companies
with higher levels of downside protection and income generation. However, the data demonstrates that, when paired
together, these factors have achieved results beyond what
either factor has achieved alone.
Average Dividend Yield (01/01/1990-12/31/2011)
4.33%
4.12%
1.25%
Building on the quartile analysis from before, the charts on
the following page demonstrate the results that occur when
grouping companies in the highest quartile of free cash flow
yield and the highest quartile of dividend yield.
In Figure 8 we see that these securities have generated
the highest level of total return when compared to either
dividend yield or free cash flow yield alone, or the equal
weighted holdings of the Russell 1000 Index. In terms of
income production, the highest dividend yield and free cash
flow yield segment also has the highest level of average
dividend yields, as depicted in Figure 9, implying that the
income generation has been higher.
1st Quartile
(Highest Free
Cash Flow
Yield and
Dividend Yield)
1st Quartile
(Highest
Dividend Yield)
Russell 1000
Holdings Equal
Weighted
Source: FactSet
Analysis: Manning & Napier
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Free Cash Flow and Dividends:
How A Focus on Yield Can Help Investors Provide For Today and Prepare For Tomorrow | A White Paper by Manning & Napier
Figure 10 shows similar synergies in regards to downside
protection. Companies with the highest dividend yields and
free cash flow yields have shown a better downside capture
ratio since 1990. And lastly, in Figure 11, we can see that
this segment also has the most attractive returns over the
last two sustained stock market declines spanning from
04/01/2000 to 09/30/2002 and 11/01/2007 to 02/28/2009.
Intuitively, these results make sense given what we know
dividend yields and free cash flow yields communicate to
investors. Along with indicating an attractive price, higher
dividend yields may often signal a company’s willingness
to return capital to shareholders. Similarly, because of
the signal of financial strength and attractive pricing that
free cash flow yield signals, investors may interpret this
measure as the ability of a company to pay a consistent and
generous dividend. Companies that show these aspects
together, (i.e., a willingness to pay and an ability to pay)
appear to offer attractive total returns, high levels of income
and better downside protection.
Conclusion
Based on the research presented in this paper, stocks
with both a high free cash flow yield and dividend yield
appear well positioned to compliment the traditional roles
that bonds and stocks have played in investor’s portfolios.
These factors utilize a security’s price to identify attractively
priced stocks offering fundamental value that should be
recognized by the market over time. Empirically, we have
also shown that over long time periods (spanning since
1990) this segment of the market has provided competitive
total returns coupled with excellent income generation and
superior downside protection. Looking ahead, investors
with a need for cash generation today and capital growth
in the future may wish to consider an investment approach
that takes advantage of high free cash flow yielding, high
dividend yielding stocks.
Figure 10: Free Cash Flow Yield and
Dividend Yield Quartiles
Downside Capture Ratio (01/01/1990-12/31/2011)
109.99%
95.03%
79.48%
71.33%
1st Quartile
(Highest Free
Cash Flow
Yield and
Dividend Yield)
1st Quartile
(Highest
Dividend Yield)
1st Quartile
(Highest Free
Cash Flow
Yield)
Russell 1000
Holdings Equal
Weighted
Relative to the Russell 1000 Index
Source: FactSet
Analysis: Manning & Napier
Figure 11: Free Cash Flow Yield and
Dividend Yield Quartiles
Annualized Total Return Over Sustained Market Declines
(04/01/2000-09/30/2002 and 11/01/2007-02/28/2009)
-10.70%
-14.53%
-13.64%
-26.50%
1st Quartile
(Highest Free
Cash Flow
Yield and
Dividend Yield)
1st Quartile
(Highest
Dividend Yield)
1st Quartile
(Highest Free
Cash Flow
Yield)
Russell 1000
Holdings Equal
Weighted
Source: FactSet
Analysis: Manning & Napier
The data presented is for informational purposes only. It is not to be considered a specific stock recommendation.
Sources: Bloomberg, FactSet, Ibbotson Associates, Ned Davis Research, Inc.
1
The Russell 1000® Index is an unmanaged index that consists of 1,000 large-capitalization U.S. stocks. The Index returns are based on a market capitalization-weighted average of relative price changes of the
component stocks plus dividends whose reinvestments are compounded daily. The Index returns do not reflect any fees or expenses.
2
The S&P 500 Total Return Index is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-theCounter market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses.
Approved CAG-CM PUB032 (4/12)
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