The majority of Canadian investors love dividends, and it is the dream of dividend investors that one day the annual dividends received will equal their cost basis, allowing investors to pass their holdings on to the next generation.

Dividends are “real money” — they can be either spent or reinvested. Dividend income also provides the predictability and stability that many investors seek, especially retirees focused on income or risk-averse investors. In addition, dividend income receives favourable treatment under the tax system through the dividend tax credit. As a result, numerous public companies proudly highlight their decades-long track records of consistent and growing dividend payments as a badge of honour. Moreover, the market tends to reward such consistency with higher valuation multiples, as sustainable dividend growth signals strong underlying fundamentals.

The problem is that sometimes companies raise dividends for reasons other than growth in fundamentals. For example, companies may be incentivized to raise dividends to be included in certain ETFs or funds, or simply to maintain a long-standing track record of dividend increases as a badge of honour despite near-term challenges.

Dividend yield is only the tip of the iceberg, and investors need to dig deeper to understand the underlying economics of the business. What investors want to see is sustainable dividend growth supported by equivalent growth in earnings or cash flow, rather than financial engineering or borrowing debt to fund dividend increases.

Therefore, investors should look for companies with healthy free cash flow yields that allow them to support their dividends. To address this, investors can look at Free Cash Flow (FCF) yield, which is calculated as free cash flow divided by market capitalization, and compare it with dividend yield. Combining these two variables gives investors a good idea of which stocks currently have a strong ability to service their dividend yields.

Below, we have screened for companies with the following criteria:

• Dividend yield of at least 2%
• Free Cash Flow yield at least equal to dividend yield
• Return on Equity of at least 12%
• Market capitalization greater than $100 million
• 5-year revenue compounded annual growth rate (CAGR) of at least 2%
• Net debt/EBITDA over the last twelve months no greater than 4.0x

The criteria above include companies paying moderate to generous dividends with yields of at least 2%. These companies’ dividends are supported by free cash flow on the trailing twelve months basis. In addition, we present important financial metrics such as 5-year average revenue growth (at least 2%), net debt/EBITDA (no greater than 4.0x), and Return on Equity (ROE) of at least 12%. As usual, we prefer companies with market capitalizations above $100 million, as these companies have generally proven themselves to be more mature, self-sustaining entities with better liquidity.

We think there are several names on the list that look promising for members to conduct further in-depth research, such as Canadian Natural Resources (CNQ), Stingray Group (RAY.A), and Intact Financial Corporation (IFC).

Lastly, the companies on this list are not recommendations, but rather a starting point to help investors generate potential investment ideas.

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Disclosure: The analyst(s) responsible for this report do not have a financial or other interest in the securities mentioned.