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 see how that's changed over the past five years.

The company we're looking at today is Airgas (NYSE: ARG), which yields 1.8%.

Industry
Airgas is a producer of industrial, medical, and specialty gases. The company, along with competitors Fastenal (Nasdaq: FAST) and MSC Industrial Direct (NYSE: MSM), have been doing well -- so well, in fact, that this year Airgas had to fend off a bid from rival Air Products and Chemicals (NYSE: APD).

Airgas Total Return Price Chart

Airgas 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.

Airgas Dividend Chart

Airgas Dividend Chart by YCharts

Airgas' dividend has been steadily rising since 2007.

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.

Airgas Times Interest Earned (TTM) Chart

Airgas Times Interest Earned (TTM) Chart by YCharts

Airgas covers every dollar in interest expense with $9 in 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's 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.

Argpayoutratio

Source: S&P Capital IQ.

Until 2010 Airgas' payout ratios had been fairly stable. The earnings payout ratio has remained below 40%.

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.