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

The company we're looking at today is Prospect Capital (Nasdaq: PSEC), which yields 13.3%.

Prospect Capital, like peers Harris & Harris (Nasdaq: TINY) and Kohlberg Capital (Nasdaq: KCAP), is a business development company (BDC). From our "Guide to Business Development Companies", a BDC is "a closed-end management investment company that makes long-term private investments. For tax purposes, it is structured as a regulated investment company (RIC), which means that the company has to pay much of its taxable income out to shareholders as dividends."

Prospect Capital Corporation Total Return Price Chart

Prospect Capital Corporation 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.

Prospect Capital Corporation Dividend Chart

Prospect Capital Corporation Dividend Chart by YCharts

Prospect Capital cut its dividend in 2010 from $0.41 per quarter to $0.10 per month.

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, which is calculated by earnings before interest and taxes, divided by interest expense. The interest coverage ratio measures a company's ability to pay the interest on its debt. A ratio less than 1.5 is questionable; a number less than 1 means the company is not bringing in enough money to cover its interest expenses.

Prospect Capital Corporation Times Interest Earned TTM Chart

Prospect Capital Corporation Times Interest Earned TTM Chart by YCharts

Prospect Capital covers every $1 in interest expense with just over $5 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's health. The FCF payout ratio measures the percent of free cash flow devoted toward paying the dividend. Again, a ratio greater than 80% could be a red flag.

Source: S&P Capital IQ.

Propsect Capital's payout ratios have been all over the place, but lately, the earnings payout ratio has settled down around 80%-90%.


Source: S&P Capital IQ.

There are some alternatives in the industry. Apollo Investment (Nasdaq: AINV) has a high trailing yield of 18% but negative earnings. TICC Capital (Nasdaq: TICC) has a trailing yield of 12% and a payout ratio of 98%. MVC Capital (NYSE: MVC) rounds out the lot with a yield of 4.1% and a payout ratio of 230%.

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.

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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.