Not all dividends are created equal. Here, we'll do a top-to-bottom analysis of a given company to understand the quality of its dividend and how that's changed over the past five years.

The company we're looking at today is SeaDrill (NYSE: SDRL), which yields 9%.

Industry
SeaDrill is a deep-sea driller owned largely by John Fredricksen, the founder and CEO who is also behind shipper Frontline (NYSE: FRO) which has been hurting as of late. The company, along with competitors Transocean (NYSE: RIG) and recent DryShips (Nasdaq: DRYS) spinoff Ocean Rig (Nasdaq: ORIG), have been profiting handsomely from oil companies' exploration of the deep-sea floor. The companies have been doing well, although all took a big dip during the drilling moratorium in the Gulf of Mexico.

Seadrill Total Return Price Chart

Seadrill Total Return Price Chart by YCharts

Dividend
To evaluate the quality of a dividend, the first thing to consider is whether the company has paid a dividend consistently over the past five years, and, if so, how much has it grown.

Seadrill Dividend Chart

Seadrill Dividend Chart by YCharts

Since its IPO in 2010, SeaDrill's dividend has been volatile.

Immediate safety
To understand how safe a dividend is, we use three crucial tools, the first of which is:

  • The interest coverage ratio, or the number of times interest is earned, which is calculated by 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. A ratio less than 1.5 is questionable; a number less than 1 means the company is not bringing in enough money to cover its interest expenses.

Seadrill Times Interest Earned (TTM) Chart

Seadrill Times Interest Earned (TTM) Chart by YCharts

SeaDrill covers every dollar of interest expense with nearly $10 of operating earnings.

Sustainability
The other tools we use to evaluate the safety of a dividend are:

  • 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 percent of free cash flow devoted toward paying the dividend. Again, a ratio greater than 80% could be a red flag.

Source: S&P Capital IQ. Periods where ratios are not meaningful are not displayed.

SeaDrill's payout ratio has been as volatile as its dividends.

Another tool for better investing
Most investors don't keep tabs on their companies. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. We can help you keep tabs on your companies with My Watchlist, our free, personalized stock-tracking service.