Not all dividends are created equal. Here, we'll do a top-to-bottom analysis of a given company to understand the quality of its dividend and see how that's changed over the past five years.

The company we're looking at today is Southern (NYSE: SO), which yields 4.5%.

Southern is an electrical utility that has not taken part in the merger resurgence in the utility sector that has seen Duke Energy (NYSE: DUK) working to merge with Progress Energy (NYSE: PGN) and PPL (NYSE: PPL) buying German utility EON's U.K. power assets. Over the past five years, Southern has done very well.

Southern Company Total Return Price Chart

Southern Company Total Return Price Chart by YCharts

To evaluate the quality of a dividend, the first thing to consider is whether the company has paid a dividend consistently over the past five years, and, if so, how much has it grown.

Southern Company Dividend Chart

Southern Company Dividend Chart by YCharts

Southern has steadily been raising its dividend the past five years.

Immediate safety
To understand how safe a dividend is, we use three crucial tools, the first of which is:

  • The interest coverage ratio, or the number of times interest is earned, which is calculated by 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. A ratio less than 1.5 is questionable; a number less than 1 means the company is not bringing in enough money to cover its interest expenses.

Southern Company Times Interest Earned (TTM) Chart

Southern Company Times Interest Earned (TTM) Chart by YCharts

Southern generates just less than $5 in operating earnings for every dollar of interest expense.

The other tools we use to evaluate the safety of a dividend are:

  • 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 than 80% could be a red flag.

Source: S&P Capital IQ.

Although Southern's free cash flow payout ratio has been volatile, its earnings payout ratio has been steady near 80%.

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.