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 Brown-Forman (NYSE: BF-B)(NYSE: BF-A), which yields 1.9%.

Industry
Brown-Forman is one of the giants of the alcoholic beverages industry, along with Diageo (NYSE: DEO), Constellation Brands (NYSE: STZ), and Beam (Nasdaq: BEAM). Its Jack Daniel's brand is a key differentiator in keeping competitors at bay.

Brown-Forman Corporation Total Return Price Chart

Brown-Forman Corporation 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 it has grown.

Brown-Forman Corporation Dividend Chart

Brown-Forman Corporation Dividend Chart by YCharts.

Brown-Forman has slowly but steadily increased its quarterly dividend from $0.25 a quarter in 2007 to $0.35 per quarter in the most recent quarter.

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.

Brown-Forman Corporation Times Interest Earned (TTM) Chart

Brown-Forman Corporation Times Interest Earned (TTM) Chart by YCharts.

Brown-Forman covers every dollar in interest expense with nearly $29 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.

Brown-Forman's payout ratio has historically been low.

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.