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 (NYSE: BTI) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

British American Tobacco

4.1%

8.5

79.1%

69.3%

Altria Group (NYSE: MO)

5.7%

5.6

46.3%

106.9%

Philip Morris International (NYSE: PM)

3.6%

13.0

29.3%

50.8%

Lorillard (NYSE: LO)

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.