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 (NYSE: PWE), which yields 5.5%.

Industry
Penn West Petroleum is an exploration and production company in Canada. The company, along with peers Pengrowth Energy (NYSE: PGH) and Enerplus Resources (NYSE: ERF), used to be Canadian royalty trusts. These were similar to the U.S. master limited partnerships that gave pass-through tax status. However, in 2006, the Canadian government stopped allowing the favorable tax treatment, and the trusts had to convert to corporations. With the higher taxes, the structures had to cut their dividends, which hurt their share prices.

Penn West Petroleum 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.

Penn West Petroleum Dividend Chart by YCharts

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.

 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.

Penn West Petroleum 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.

Penn West Petroleum used to pay out the majority of its earnings as a trust. It still pays out a large of its earnings.

Alternatives

Source: S&P Capital IQ.

There are some alternatives out there in the industry. Encana (NYSE: ECA) and Canadian Natural Resources (NYSE: CNQ) both have negative free cash flow ratios along with Penn West, but they both yield less. Suncor Energy (NYSE: SU) has a low yield of 1.6% but a healthier payout ratio of just 30%.

Another tool for better investing
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