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 one 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's 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.
Each of these ratios reflect dividends paid in the trailing twelve months while yields are the expected forward yield. Let's examine British American Tobacco
Company |
Yield |
Interest Coverage |
EPS Payout Ratio |
FCF Payout Ratio |
---|---|---|---|---|
British American Tobacco |
4.1% |
8.5 |
79.1% |
69.3% |
Altria Group |
5.7% |
5.6 |
46.3% |
106.9% |
Philip Morris International |
3.6% |
13.0 |
29.3% |
50.8% |
Lorillard |
4.6% |
16.8 |
65.0% |
56.0% |
Source: Capital IQ, a division of Standard & Poor's.
With an interest coverage of 8.5, British American Tobacco covers every $1 in interest expenses with more than $8 in operating earnings. Given that its EPS payout ratio is below 80%, and its FCF payout ratio is below 70%, you shouldn't have to worry that Valero 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.
- Add British American Tobacco to My Watchlist.
- Add Altria Group to My Watchlist.
- Add Philip Morris International to My Watchlist.
- Add Lorillard to My Watchlist.