Dividend investors know that it pays to follow how much of a company's money goes toward funding its payouts. 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 percentage of free cash flow devoted toward paying the dividend. Again, a ratio greater 80% could be a red flag.

Let's examine Best Buy (NYSE: BBY) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
Best Buy

2.1%

26.9

19.2%

72.6%
Costco Wholesale (Nasdaq: COST)

1.2%

17.5

26.9%

19.6%*
Wal-Mart Stores (NYSE: WMT)

2.7%

11.4

27.7%

55.5%
Target (NYSE: TGT)

2.5%

7.0

24.4%

19.1%

Source: Capital IQ, a division of Standard & Poor's.
*For the quarter ended February 2011.

With an interest coverage of 26.9, Best Buy covers every $1 in interest expenses with roughly $27 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 75%, you shouldn't have to worry that Best Buy will need to cut its dividend anytime soon. Best Buy has been doing well, and some analysts think it's a buy.

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.