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.
Let's examine how J.C. Penney
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.
J.C. Penney yields 2.1%, just 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.
J.C. Penney doesn't have a payout ratio because the company reported negative earnings over the past year. But those losses were largely due to restructuring charges. On both a normalized basis and a free cash flow basis, the company paid out basically 100% of its earnings.
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.
J.C. Penney has a debt-to-equity ratio of 78% and, based on 2011's weak operating earnings, has an interest coverage rate of 2 times.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Over the past five years, J. C. Penney's dividend has grown at an average annual rate of 2%, while its operating earnings have shrunk at a 23% rate. However, with new leadership, a new logo, a new pricing structure, and better-than-expected same-store-sales growth, J.C. Penney could be in the early innings of a turnaround.
The Foolish bottom line
So is J.C. Penney a dividend dynamo or a blowup? With a high payout ratio, a low interest coverage rate, and shrinking earnings, J.C. Penney seems to be much closer to "dividend blowup" than "dividend dynamo." But if a turnaround does materialize, as analysts expect it to, it's possible the company may be able to hang on to its payouts at current levels until its financials improve. However, if you're looking for some great dividend stocks, I suggest you check out "Secure Your Future With 11 Rock-Solid Dividend Stocks," a special report from The Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these 11 generous dividend payers.
Ilan Moscovitz doesn't own shares of any company mentioned. 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.