Not all dividends are created equal. Here, we'll do a top-to-bottom analysis of a given company to understand the quality of its dividend and how that's changed over the past five years.
The company we're looking at today is Chesapeake Energy
Chesapeake is an exploration and production company focused on natural gas. Chesapeake has one large advantage over other players in that it has its own drilling fleet and does not have to contract out to drilling companies, as competitor Kodiak Oil & Gas
To evaluate the quality of a dividend, the first thing to consider is whether the company has paid a dividend consistently over the past five years, and if so, how much it has grown.
Chesapeake's dividend has been paid consistently for the past five years and has been raised three times since 2007, for a five-year growth rate of 8.1%.
To understand how safe a dividend is, we use three crucial tools, the first of which is:
- The interest coverage ratio or the number of times interest is earned, calculated by 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.
At 58.44, Chesapeake covers every $1 of interest expense with $58 of operating earnings.
The other tools we use to evaluate how safe a dividend is:
- 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.
Source: S&P Capital IQ.
Chesapeake has been reinvesting more in its operations than it has brought in in cash over the past five years, and as such it does not have a free cash flow payout ratio to report. On an earnings basis, Chesapeake's payout ratio is 15.9% for the most recent quarter.
Source: S&P Capital IQ.
With negative free cash flow payout ratio and a low yield, there are some alternatives out there in the industry; unfortunately, they aren't much better. In the exploration and production sector, Devon Energy
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.
Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting. The Motley Fool owns shares of Devon Energy. Motley Fool newsletter services have recommended buying shares of Chesapeake Energy. 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.