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 than 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 McGraw-Hill (NYSE: MHP)and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
McGraw-Hill 2.3% 18.9 35.7% 24.5%
R.R. Donnelley & Sons (NYSE: RRD) 6.4% 3.0 169.8% 56.4%
Avery Dennison (NYSE: AVY) 3.6% 6.0 7.6% 40.8%
Gannett (NYSE: GCI) 2.6% 5.6 9.4% NA

Source: S&P Capital IQ.

With an interest coverage of 18.9, McGraw-Hill covers every $1 in interest expenses with $19 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are at or below 35%, you shouldn't have to worry that McGraw-Hill will need to cut its dividend anytime soon.

Another tool for better investing
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