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.
Atlantic Power yields a whopping 8%, considerably 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.
Atlantic Power doesn't have a payout ratio because it's lost money over the past year. Although it generated enough free cash flow to cover its dividend in 2009, it wouldn't have been enough money to cover current payouts.
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.
Atlantic Power has a moderate debt-to-equity ratio of 152% and an interest coverage rate of 0.7 times, meaning operating income clocked in lower than interest payments last year. That was also the case from 2007 through 2009.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Out of the past several years, Atlantic Power only generated earnings in 2008, although it did produce some free cash flow in 2008 and 2009.
The Foolish bottom line
So is Atlantic Power a dividend blowup? The company hasn't yet shown it can generate enough earnings or free cash flow to cover its current level of payouts. There are alternatives to dividend cuts, like selling more stock or debt, but unless profits improve, they would only prolong the inevitable. I wouldn't be interested in this one for its dividend unless I either saw higher earnings or free cash flow, or could stomach lower payouts. However, if you're looking for some solid 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 -- simply click here.
Ilan Moscovitz doesn't own shares of any company mentioned. 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.