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 Pepco (NYSE: POM), which yields 5.3%.

Pepco is an electic utility. When the electricity market went through deregulation, utilities had to choose between being distributors or producers. Pepco's electricity is sold in a largely regulated market. Since the company is largely regulated, the stock is stable like the average utility company.

Pepco Total Return Price Chart

Pepco 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.

Pepco Dividend Chart

Pepco Dividend Chart by YCharts

Pepco last raised its dividend in 2008 from $0.26 per quarter to $0.27 per quarter.

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.

Pepco Times Interest Earned TTM Chart

Pepco Times Interest Earned TTM Chart by YCharts

Pepco covers every $1 in interest expense with just over $2.50 in operating earnings.

The other tool we use to evaluate the safety of a dividend is:

  • 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.

Source: S&P Capital IQ.

Pepco's payout ratio went sky-high during the recession, but has since come down to its current level of 90%.


Source: S&P Capital IQ.

There are some alternatives in the industry, though none with as high a yield as Pepco's. Coming closest is TECO Energy (NYSE: TE), with a 4.5% yield and a 65% payout ratio. NorthWestern (NYSE: NWE) is next with a yield of 4% and a payout ratio of 63%. Last but not least is Northeast Utilities (NYSE: NU), with a yield of 3.1% and a payout ratio of 47%.

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.