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 Waste Management (NYSE: WM), which yields 4.5%.

Waste Management is one of the largest waste-services companies in the United States. The company, along with competitors Republic Services (NYSE: RSG) and Progressive Waste Solutions (NYSE: BIN), has been doing well since, no matter the economy, trash still needs to be collected.

Waste Management Total Return Price Chart

Waste Management 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 it has grown.

Waste Management Dividend Chart

Waste Management Dividend Chart by YCharts

After briefly suspending its dividend in 2008, the dividend has continuously risen since then.

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 of less than 1.5 is questionable; a number less than 1 means that the company isn't bringing in enough money to cover its interest expenses.

Waste Management Times Interest Earned TTM Chart

Waste Management Times Interest Earned TTM Chart by YCharts

Waste Management covers each $1 of interest expense with just over $4 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.

Waste Management has been increasing its dividend faster than its earnings and free cash flow have been increasing, resulting in steadily rising payout ratios. With both ratios below 70%, you need not be worried.


Source: S&P Capital IQ.

There are some alternatives out there in the industry. U.S. Ecology (Nasdaq: ECOL) has a yield of 4.2% but a higher payout ratio of 71%. General Electric (NYSE: GE) has a payout ratio of 4.1% but isn't free cash flow positive and as such has a negative payout ratio. Rounding out the group is Waste Connections (NYSE: WCN), with a 1.1% yield and a 14% payout ratio

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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.