As a dividend investor, it pays to follow how much of a company's money goes toward funding its dividend. A nice yield now won't matter much if the company can't keep making those payments going forward.

Here, we'll highlight a given company and its closest competitors to see just how safe their dividends are, with a little help from three crucial tools:

  • The interest coverage ratio, or 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. 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.
  • 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 percent of free cash flow devoted toward paying the dividend. Again, a ratio greater than 80% could be a red flag.

Let's examine PACCAR (Nasdaq: PCAR) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

PACCAR

0.9%

759

26.4%

72.8%

Cummins (NYSE: CMI)

1.0%

37.2

15.3%

98.2%

Caterpillar (NYSE: CAT)

1.7%

16.2

31.3%

80.4%

Danaher (NYSE: DHR)

0.1%

19.4

2.8%

4.2%

Source: Capital IQ, a division of Standard & Poor's.

With an interest coverage of 759, PACCAR covers every $1 in interest expenses with $759 in operating earnings. An EPS payout ratio of 26.4% means the dividend is safe from an earnings perspective. A FCF payout ratio of 72% is manageable, so you shouldn't worry much that PACCAR will need to cut its dividend anytime soon.

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 MyWatchlist, our free, personalized stock-tracking service.