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.

Each of these ratios reflect dividends paid in the trailing 12 months; yields are the expected forward yield. Let's examine Cisco Systems (Nasdaq: CSCO) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
Cisco Systems

1.6%

13.7

4.7%

6.3%
Hewlett-Packard (NYSE: HPQ)

1.4%

31.0

7.9%

9.5%
Maxim Integrated Products (Nasdaq: MXIM)

3.6%

77.6

60.5%

66.7%
Qualcomm (Nasdaq: QCOM)

1.6%

41.4

33.0%

70.9%

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

With an interest coverage ratio of 13.7, Cisco covers every $1 in interest expenses with just under $14 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 10%, you shouldn't have to worry that Cisco will need to cut its dividend anytime soon. The company has been getting crushed, but some think Cisco deserves a spot on your watchlist.

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