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.

Each of these ratios reflect dividends paid in the trailing 12 months; yields are the expected forward yield. Let's examine Vale (NYSE: VALE) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
Vale

2.6%

20.7

12.0%

72.4%
BHP Billiton (NYSE: BHP)

2.0%

141.8

29.7%

42.6%
Freeport-McMoRan Copper & Gold (NYSE: FCX)

1.8%

24.0

12.2%

17.7%
Cliffs Natural Resources (NYSE: CLF)

1.2%

17.4

5.6%

9.0%

Source: Capital IQ, a division of Standard & Poor's.

With an interest coverage ratio of 20.7, Vale covers every $1 in interest expenses with just under $21 in operating earnings. While its EPS payout ratio is below 15%, the company's FCF payout ratio is a slightly worrisome 72.4%. You shouldn't have to worry, though, as Vale's FCF payout ratio was boosted by some one-time acquisitions, so Vale shouldn't need to cut its dividend anytime soon.

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