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 one 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's 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 IBM (NYSE: IBM) and three of its peers.

Company

Yield

Interest Coverage

EPS Payout Ratio

FCF Payout Ratio

IBM

1.8%

53.4

21.8%

26.8%

Intel (Nasdaq: INTC)

3.6%

>1,000

30.4%

47.7%

Hewlett-Packard (NYSE: HPQ)

1.3%

44.5

7.9%

9.5%

Cisco Systems (Nasdaq: CSCO)

1.5%

13.7

0%

6.2%

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

With an interest coverage of 53.4, IBM covers every $1 in interest expenses with more than $53 in operating earnings. Given its EPS payout ratio and FCF payout ratio are below 30%, you shouldn't have to worry that IBM 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 My Watchlist, our free, personalized stock-tracking service.