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 than 80% could be a red flag.
Each of these ratios reflects dividends paid in the trailing 12 months, while yields are the expected forward yield. Let's examine Applied Materials
Company |
Yield |
Interest Coverage |
EPS Payout Ratio |
FCF Payout Ratio |
---|---|---|---|---|
Applied Materials | 2.5% | 66.5 | 20.7% | 20.7% |
KLA-Tencor |
3.0% | 24.1 | 22.5% | 29.0% |
Linear Technology |
2.9% | 14.8 | 39.9% | NA |
Cognex |
1.0% | NA | 18.3% | 23.6% |
Source: S&P Capital IQ.
With an interest coverage of 66.5, Applied Materials covers every $1 in interest expenses with $67 in operating earnings. Given that its EPS payout ratio and FCF payout ratio are below 25%, you shouldn't have to worry that Applied Materials 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.
- Add Applied Materials to My Watchlist.
- Add KLA-Tencor to My Watchlist.
- Add Linear Technology to My Watchlist.
- Add Cognex to My Watchlist.