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 Penn West Petroleum
Penn West Petroleum is an exploration and production company in Canada. The company, along with peers Pengrowth Energy
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.
When Penn West had to convert to a corporation and lost its tax treatment, the company was forced to cut its dividend. Since then, it has been slowly raising it back to its previous level.
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.
Penn West Petroleum has no debt and as such has no interest expense to cover.
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.
Penn West Petroleum used to pay out the majority of its earnings as a trust. It still pays out a large of its earnings.
Source: S&P Capital IQ.
There are some alternatives out there in the industry. Encana
Another tool for better investing
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