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 PepsiCo (NYSE: PEP), which yields 3.3%.

Pepsi has been doing well -- it reported stellar earnings in early October and was quickly followed by fellow beverage companies Coca-Cola (NYSE: KO), Dr Pepper Snapple (NYSE: DPS), and Hansen Natural (Nasdaq: HANS). While Coke has been beating Pepsi in the soda game, Coke and Diet Coke now both have more market share than Pepsi, but PepsiCo has large snacks brands that have been keeping its growth higher than its better-tasting competitor.

PepsiCo Total Return Price Chart

PepsiCo Total Return Price Chart by YCharts.

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 has it grown.

PepsiCo Dividend Chart

PepsiCo Dividend Chart by YCharts.

While Pepsi's stock hasn't really gone anywhere, its dividend has steadily climbed.

Immediate safety
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, which is 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. A ratio less than 1.5 is questionable; a number less than one means the company is not bringing in enough money to cover its interest expenses.

PepsiCo Times Interest Earned (TTM) Chart

PepsiCo Times Interest Earned (TTM) Chart by YCharts.

PepsiCo covers every dollar in interest expense with just less than $10 in operating earnings.

The other tools we use to evaluate the safety of a dividend are:

  • 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.

Pepsi's payout ratio has fairly stable, around 50%-60% for the past five years.

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.