In the past year, a friend of mine has shifted a large percentage of his portfolio to stable, dividend paying companies from growth stocks. The allure of a steady stream of dividends overcame his desire for capital appreciation. He is not alone in his quest but is he correct to place a greater emphasis on dividends than on capital appreciation?

I do not think this is an either/or proposition. Dividends contribute significantly to an investment’s total return. Ibbotson Associates estimates that over the very long term, dividends contribute as much as 40% to total return. However, the largest gains in total return are derived from capital appreciation. To resolve this dichotomy, I try to identify undervalued dividend paying stocks. The income stream provides a certain level of support while I wait for the market to recognize the value in company I select.

I constructed a screen for my database to identify such companies. I looked for companies paying an above market average dividend yield, cash flow return on invested capital greater than 12% and return on equity greater than 18%. These criteria assure me that the company is currently profitable and has meaningful free cash flow. My valuation metrics include Enterprise Value to Sales (EV/sales), Enterprise Value to Invested Capital (EV/IC) and Price to Book Value (PBV). For each metric, I estimate the “correct” multiple using factors such as EPS growth, Return on Invested Capital (ROIC), debt to capital ratios, operating margins, payout, among others. I eliminate companies in the real estate and financial sectors and companied with market capitalizations under $250 million. This screen provided a diverse list of 28 companies.

One unintended consequence of this screen is that six of the 28 companies are takeover targets or potential takeover targets. Lubrizol is being acquired by Berkshire Hathaway. The utility company DPL Inc. is being acquired by AES for $3.5 billion. Reuters Insider analysts identify Parker-Hannifin as a possible target for Berkshire Hathaway. Barron’s Magazine published a list of potential LBO candidates compiled by UBS analysts Randy Udell and Ben Canet. The list includes McGraw-Hill and Ross Stores. Lastly, there are published rumors that Johnson & Johnson is interested in Smith & Nephew.

We always look at the balance sheet. If you buy a stock for the dividend, you want to be sure the company can sustain that dividend. Growth companies need a strong balance sheet to maintain that growth.

Last, but not least, is the income statement. Are earnings projected to grow? Is there free cash flow available to fund the dividends and, perhaps more importantly, growth in dividend payout? Is the dividend payout excessive or is there room to grow here too?

This list provides a selection of companies, from mega-cap XOM to micro-cap AAON. Each company appears to be financial strong with good growth prospects. None have excessive payouts unsupported by free cash flow. Judging from the number of announced buyouts, rumors of takeovers and possible targets, others share our view that these are undervalued in today’s market and offer the possibility of a total return greater than what the market offers.

As with all lists of this sort, this is a starting point for additional thought and research.