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 Prospect Capital (Nasdaq: PSEC ) , which yields 13.3%.
Industry
Prospect Capital, like peers Harris & Harris (Nasdaq: TINY ) and Kohlberg Capital (Nasdaq: KCAP ) , is a business development company (BDC). From our "Guide to Business Development Companies", a BDC is "a closed-end management investment company that makes long-term private investments. For tax purposes, it is structured as a regulated investment company (RIC), which means that the company has to pay much of its taxable income out to shareholders as dividends."
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 it has grown.
Prospect Capital cut its dividend in 2010 from $0.41 per quarter to $0.10 per month.
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.
Prospect Capital covers every $1 in interest expense with just over $5 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.
Source: S&P Capital IQ.
Propsect Capital's payout ratios have been all over the place, but lately, the earnings payout ratio has settled down around 80%-90%.
Alternatives
Source: S&P Capital IQ.
There are some alternatives in the industry. Apollo Investment (Nasdaq: AINV ) has a high trailing yield of 18% but negative earnings. TICC Capital (Nasdaq: TICC ) has a trailing yield of 12% and a payout ratio of 98%. MVC Capital (NYSE: MVC ) rounds out the lot with a yield of 4.1% and a payout ratio of 230%.
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.
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