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 McDonald's (NYSE: MCD) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio
McDonald's 3% 16.2 49% 76.5%
Yum! Brands (NYSE: YUM) 1.8% 9.4 39.7% 44.4%
Darden Restaurants (NYSE: DRI) 2.6% 7.4 37.7% 149.9%
Wendy's/Arby's Group (NYSE: WEN) 1.7% 1.4 -1293.9% 46.7%

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

With an interest coverage of 16.2, McDonald's covers every $1 in interest expenses with $16 in operating earnings. Given its FCF payout ratio is nearing 80% investors should watch this number closely in the quarters ahead.

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.