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 Alcoa (NYSE: AA), which yields 1.4%.

Alcoa is a producer of aluminum. The company's stock was crushed by the recession and has only slowly started to come back. As a bellwether for the economy, Alcoa's doldrums don't bode well for the economy. However, longer term, things are looking up as Alcoa expects a doubling in demand for aluminum by 2020.

Alcoa Total Return Price Chart

Alcoa 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.

Alcoa Dividend Chart

Alcoa Dividend Chart by YCharts

Alcoa's dividend was cut in 2009 to $0.03 per quarter, where it has remained since.

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.

Alcoa Times Interest Earned TTM Chart

Alcoa Times Interest Earned TTM Chart by YCharts

Alcoa covers every $1 in interest expense with more than $4 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.

Alcoa's payout ratio has always been low, but during the recession, Alcoa's earnings turned negative. In the past two years, Alcoa returned to profitability, and its payout ratio has remained low.


Source: S&P Capital IQ.

There are some alternatives in the industry that make higher payouts. Nucor (NYSE: NUE) has the largest dividend yield at 3.6% but also has a high payout ratio of 73% to go with it. Freeport-McMoRan (NYSE: FCX) has a yield of 2.6% and a payout ratio of 16%. AK Steel (NYSE: AKS) has a yield of 2.4% but a negative 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.

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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.