As a dividend investor, it pays to follow how much of a company's money goes toward funding its dividend. A nice yield now won't matter much if the company can't keep making those payments going forward.

Here, we'll highlight a given company and its closest competitors to see just how safe their dividends are, with a little help from three crucial tools:

  • The interest coverage ratio, or 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. An interest coverage ratio less than 1.5 is questionable; a number less than 1 means that the company is not bringing in enough money to cover its interest expenses.
  • 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 80% could be a red flag.

Let's examine KLA-Tencor (Nasdaq: KLAC) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

KLA-Tencor

2.3%

14.7

23.1%

47.7%

Linear Technology (Nasdaq: LLTC)

2.8%

12.9

39.4%

60.6%

Cognex (Nasdaq: CGNX)

1.1%

NM

17.4%

23.9%

Applied Materials (Nasdaq: AMAT)

2.2%

110.9

27.5%

23.0%

Source: Capital IQ, a division of Standard & Poor's. NM = not meaningful; Cognex had no interest expense during the period.

With an in terest coverage of 14.7, KLA-Tencor covers every $1 in interest expenses with $14.70 in operating earnings. And given its EPS payout ratio and FCF payout ratio are below 50%, you shouldn't have to worry that KLA-Tencor will need to cut its dividend anytime soon.

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.