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 Altria (NYSE: MO), which yields 5.6%.

Industry
Altria, like competitor Lorillard (NYSE: LO), is a manufacturer of cigarettes. Unlike Lorillard, Altria is the American manufacturer and seller of Marlboro, the No. 1 cigarette brand in the United States. In 2007 and 2008, the company went through a major restructuring. Altria spun off its food division, which became Kraft Foods (NYSE: KFT), and split up its American cigarette operations and its international operations, which became Philip Morris International (NYSE: PM). In 2009, Altria acquired UST, a maker of smokeless tobacco products that also competes with smokeless tobacco products from Star Scientific (Nasdaq: CIGX).

Altria Group Total Return Price Chart

Altria Group Total Return Price Chart by YCharts

Dividend
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.

Altria Group Dividend Chart

Altria Group Dividend Chart by YCharts

Before the two spinoffs, Altria paid a dividend of $0.75 per quarter. After the spinoffs, the dividend was cut to $0.29 per quarter and has since risen to $0.41 per quarter.

 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. It's 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 one means the company is not bringing in enough money to cover its interest expenses.

Altria Group Times Interest Earned TTM Chart

Altria Group Times Interest Earned TTM Chart by YCharts

Altria covers every $1 in interest expense with more than $5 in operating earnings.

Sustainability
The other tools we use to evaluate how safe a dividend is 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.

Altria targets a payout ratio of 80%, but lately it's been paying out slightly higher than 80%.

Alternatives

Source: S&P Capital IQ.

There are some alternatives out there in the industry. Reynolds American (NYSE: RAI) has a similarly high dividend of 5.5% but a much higher payout ratio. Philip Morris International has the lowest payout ratio and a yield of 4.1%. British American Tobacco (NYSE: BTI) rounds out the group with a 3.9% dividend and 57% payout ratio.

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.

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This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.