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 80% could be a red flag.

Let's examine Graco (NYSE: GGG) and three of its peers:

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

Graco 1.8% 47.7 41.8% 77.3%
Flowserve (NYSE: FLS) 1.1% 16.9 16.6% 115.9%
IDEX (NYSE: IEX) 1.5% 14.6 30.7% 36%
Gorman-Rupp (AMEX: GRC) 0.9% NA 24.6% 102.3%

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

With an interest coverage ratio of 47.7, Graco covers every $1 in interest expenses with more than $47 in operating earnings. Its 42% EPS payout ratio is good, but investors should watch out for Graco's FCF payout ratio, which currently stands at a much higher 77.3%.

Another tool for better investing
Most investors don't keep tabs on their companies and 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.

Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting.

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