Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.
First and foremost, dividend investors like a large yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price, and shrinking the yield.
American Electric Power yields 4.9% -- moderate and worthy of further investigation.
2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends with the amount it generates. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford.
American Electric Power’s payout ratio is a moderate 69%.
3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The interest coverage ratio indicates whether a company is having trouble meeting its interest payments -- any ratio less than 5 is a warning sign. Meanwhile, the debt-to-equity ratio is a good measure of a company's total debt burden.
Let's examine how American Electric Power stacks up next to its peers:
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Source: Capital IQ, a division of Standard & Poor's.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Over the past five years, American Electric Power's earnings per shares have shrunk by 1% annually, while its dividend has grown at a 4% rate.
The Foolish bottom line
American Electric Power exhibits a reasonable dividend bill of health. Its payouts are covered by earnings. Because of its fairly significant leverage, dividend investors looking will want to ensure that the company is able to maintain stable earnings.
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Ilan Moscovitz doesn’t own shares of any companies mentioned. You can follow him on Twitter @TMFDada. Motley Fool newsletter services have recommended buying shares of Dominion Resources and Southern. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.