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 SeaDrill
SeaDrill is a deep-sea driller, competing with other drillers such as DryShips
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.
SeaDrill's dividend has been slowly rising since its IPO in 2010. The two dips you see in the graph are special dividends the company paid out in addition to its regular quarterly dividend.
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.
At 11.36 SeaDrill covers every $1 in interest expense with over $11 in operating earnings.
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.
SeaDrill has been heavily investing in new drillships, and as such, its free cash flow payout ratio is all over the place. Its earnings payout ratio is near 70% and is more representative of the business.
Source: S&P Capital IQ.
There are some alternatives out there in the industry. SeaDrill has both the highest yield and payout ratio, but Transocean
Another tool for better investing
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Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting. The Motley Fool owns shares of Ensco and Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.