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 TransAlta
TransAlta is an electricity producer. When the electricity market went through deregulation, utilities had to choose between being distributors or producers. TransAlta's electricity is sold wholesale and as such is unregulated. Since the company is unregulated, the stock is more volatile than the average utility company.
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.
TransAlta's dividend has been stable at $0.29 per quarter since 2009.
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.
TransAlta covers every $1 in interest expense with nearly $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.
TransAlta's payout ratio was sky-high in 2006 before coming down to more reasonable levels. The company currently pays out roughly 80% of its earnings as dividends.
Source: S&P Capital IQ.
With TransAlta's volatile payout ratios, there are some alternatives in the industry. Exelon
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