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

The company we're looking at today is BP Prudhoe Bay Royalty Trust (NYSE: BPT), which yields 7%.

Industry
BP Prudhoe Bay Royalty Trust is a royalty trust of oil fields formerly owned by BP (NYSE: BP). Royalty trusts don't pay taxes at the corporate level, so the tax burden gets passed to the investor. One thing to consider, however, is that unlike normal operating businesses, most trusts are depleting assets. A good example is Whiting USA Trust I (NYSE: WHX), which is expecting to end operations in 2015. Eventually the income-producing ability of the trust will end.

BP Prudhoe Bay Royalty Trust Total Return Price Chart

BP Prudhoe Bay Royalty Trust Total Return Price Chart by YCharts

Dividend
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 it has grown.

BP Prudhoe Bay Royalty Trust Dividend Chart

BP Prudhoe Bay Royalty Trust Dividend Chart by YCharts

The trust's dividend payments fluctuate with the amount of oil the trust produces and the price the trust is able to sell its oil for.

 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, calculated by dividing earnings before interest and taxes 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.

BP Prudhoe Bay Royalty Trust has no debt and as such has no interest expense to cover.

Sustainability

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' health. The FCF payout ratio measures the percentage of free cash flow devoted to paying the dividend. Again, a ratio greater than 80% could be a red flag.

Source: S&P Capital IQ.

BP Prudhoe Bay Royalty Trust pays out all its earnings as dividends, and as such, its payout ratio is consistently at or close to 100%.

Alternatives

Source: S&P Capital IQ.

There are some alternatives out there in the industry. SandRidge Mississippian Trust I (NYSE: SDT) has the highest trailing yield; however, that's due to a one-time large dividend it paid when it started operating. The trust's forward yield is closer to 8% at today's prices. Permian Basin Royalty Trust (NYSE: PBT) offers a yield 6.1%, while Hugoton Royalty Trust (NYSE: HGT) yields 6.7%.

Another tool for better investing
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