A yield this high can bring in extraordinary income for investors, but many will not go near a stock with a 13% yield because they fear it is loaded with risk. Although in many cases this is true, Tim Plaehn shows through cash flow analysis how this company can comfortably afford this growing yield.

While I am somewhat of a small fish in the big financial publishing ocean, I always enjoy when I see my theories or observations repeated elsewhere. During a couple of recent earnings conference calls, I heard Wall Street analysts question management about unique points I have been making in my articles.

Now, one of the income stocks I follow and recommend is using an analysis technique that I use frequently to better explain how they fund those big dividends. Maybe they did not get the idea from one of my presentations, but each piece of information like this can help income investors make better investment decisions.

When analyzing high-yield stocks, traditional stock analysis metrics like earnings per share (EPS), payout ratios, and price to earnings (P/E) ratios do not provide an accurate picture of whether a company with a high dividend yield can support and grow the dividend payment. When I make presentations at investor conferences and discuss my strategy with my newsletter subscribers, I dig deeply into more advanced free cash flow analysis.

One of the companies that I use to illustrate cash flow is Ship Finance International Limited (NYSE: SFL). Ship Finance pays a large and steady dividend, but the company’s quarterly earnings per share has varied a lot, both higher and lower than the quarterly per share dividend payment.

With each quarterly earnings release presentation, Ship Finance includes a trailing twelve month cash flow waterfall style chart. I use this chart to show cash flow coverage of the dividend. For example, here is the chart from a year ago.

The rightmost blue bar shows that over the previous 12 months the company generated $186 million of unencumbered, free cash flow. I would then tell my audience that the company had paid out about $160 million in dividends over the same period. So at that point in time, Ship Finance generated enough cash flow to cover the dividend by a factor of 1.16 times.