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 forward 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.
Caterpillar yields 2.2%, basically in- ine with the S&P 500.
2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company paid out in dividends last year with the earnings it generated. 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, even when its dividend yield doesn't seem particularly high.
Caterpillar has a comfortable payout ratio of 28%.
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 Caterpillar stacks up next to its peers:
Illinois Tool Works
Source: S&P Capital IQ.
In absolute terms, Caterpillar has a moderately high debt burden, though that's fairly normal for its capital-intensive industry. Its interest coverage is strong, though it's important to remember Caterpillar's operating income is currently quite high and tends to be cyclical.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Caterpillar's earnings have grown at an annual rate of 4% over the past five years, while its dividend has grown at a rate of 11%.
The Foolish bottom line
Caterpillar exhibits a fairly strong dividend bill of health. It has a moderate yield, a modest payout ratio, a reasonable debt burden, and nice long-term growth. Dividend investors will want to keep an eye on the construction industry to ensure that the company's leverage doesn't become an issue should sales ultimately hit a bump. To stay up to speed on the top news and analysis on Caterpillar, or any other stock, add it to your stock watchlist. If you don't have one yet, you can create a free, personalized watchlist of your favorite stocks.