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.
Applied Materials yields 2.5%, a bit higher than the S&P 500's 2%.
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 to 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.
Applied Materials has a moderate payout ratio of 27%.
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 Applied Materials stacks up next to its peers:
|Applied Materials||23%||32 times|
|Veeco Instruments||0%||338 times|
|Novellus Systems||34%||19 times|
Source: S&P Capital IQ.
Like much of the tech sector, Applied Materials and its peers have a healthy tendency to take it easy on debt.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
5-Year Annual Earnings-per-Share Growth
5-Year Annual Dividend-per-Share Growth
Source: S&P Capital IQ.
It's been a rocky past several years for Applied Materials. When all is said and done, earnings are about where they were at the beginning of the period. That rockiness extends past just one company -- even Veeco, which boasts incredible average annual earnings-per-share growth, saw three of the past five fiscal years end in losses.
The Foolish bottom line
Although its earnings lumpiness may not make Applied Materials look like a traditional dividend dynamo, the company's payout ratio is small enough that it should be able to continue making payouts -- but only as long as its long-term business is solid.
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Ilan Moscovitz doesn't own shares of any company mentioned. You can follow him on Twitter @TMFDada. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.