Dividend investors know that it pays to follow how much of a company's money goes toward funding its payouts. A nice yield now won't matter much if the company can't keep making those payments going forward.

Here, we'll highlight a given company and its closest competitors to see just how safe their dividends are, with a little help from three crucial tools:

  • The interest coverage ratio, or earnings before interest and taxes, divided by interest expense. The interest coverage ratio measures a company's ability to pay the interest on its debt. An interest coverage ratio less than 1.5 is questionable; a number less than 1 means that the company is not bringing in enough money to cover its interest expenses.
  • The EPS payout ratio, or dividends per share divided by earnings per share. The EPS payout ratio measures the percentage of earnings that go toward paying the dividend. A ratio greater than 80% is worrisome.
  • The FCF payout ratio, or dividends per share divided by free cash flow per share. Earnings alone don't always paint a complete picture of a business' health. The FCF payout ratio measures the percentage of free cash flow devoted toward paying the dividend. Again, a ratio greater 80% could be a red flag.

Let's examine International Paper (NYSE: IP) and three of its peers. The company has been doing well and recently announced a hostile-takeover offer for Temple-Inland (NYSE: TIN).

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
International Paper

3.5%

3.4

21.4%

18.7%
Packaging Corp. of America (NYSE: PKG)

2.8%

7.1

29.8%

112.3%
Rock-Tenn (NYSE: RKT)

1.1%

5.6

12.4%

17.7%
Domtar (NYSE: UFS)

1.4%

8.2

7.0%

3.0%

Source: Capital IQ, a division of Standard & Poor's.

With an interest coverage of 3.4, International Paper covers every $1 in interest expenses with more than $3 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 25%, you shouldn't have to worry that International Paper will need to cut its dividend anytime soon.

Another tool for better investing
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