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 Sherwin-Williams (NYSE: SHW) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
Sherwin-Williams 1.8% 11.0 31.9% 56.7%
PPG Industries (NYSE: PPG) 2.7% 7.7 37.4% 42.0%
Valspar (NYSE: VAL) 2.0% 6.4 31.5% 38.1%*
Masco (NYSE: MAS) 2.5% 0.6 (9.6%) 28.5%

Source: Capital IQ, a division of Standard & Poor's.
*For year ended January 2011.

With an interest coverage of 11.0, Sherwin-Williams covers every $1 in interest expenses with $11 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 60%, you shouldn't have to worry that Sherwin-Williams will need to cut its dividend anytime soon. On the whole, Sherwin-Williams has been doing well, though some analysts are beginning to worry about its receivables growth.

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.