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 Pepco (NYSE: POM ) , which yields 5.3%.
Pepco is an electic utility. When the electricity market went through deregulation, utilities had to choose between being distributors or producers. Pepco's electricity is sold in a largely regulated market. Since the company is largely regulated, the stock is stable like the average utility company.
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.
Pepco last raised its dividend in 2008 from $0.26 per quarter to $0.27 per quarter.
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.
Pepco covers every $1 in interest expense with just over $2.50 in operating earnings.
The other tool we use to evaluate the safety of a dividend is:
- 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.
Source: S&P Capital IQ.
Pepco's payout ratio went sky-high during the recession, but has since come down to its current level of 90%.
Source: S&P Capital IQ.
There are some alternatives in the industry, though none with as high a yield as Pepco's. Coming closest is TECO Energy (NYSE: TE ) , with a 4.5% yield and a 65% payout ratio. NorthWestern (NYSE: NWE ) is next with a yield of 4% and a payout ratio of 63%. Last but not least is Northeast Utilities (NYSE: NU ) , with a yield of 3.1% and a payout ratio of 47%.
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.
- Add Pepco to My Watchlist.