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 UnitedHealth Group (NYSE: UNH), which yields 1.5%.

UnitedHealth is a health-care company providing all manner of health-care services. Like its competitors Humana (NYSE: HUM), Coventry (NYSE: CVH), and Wellpoint (NYSE: WLP), UnitedHealth was beat up in 2009 and 2010 as Congress debtated health-care reform. However, UnitedHealth's 8.2% operating margin bests Humana's 6.1%, Coventry's 7.9%, and Wellpoint's 7.7%.

UnitedHealth Group Operating Margin TTM Chart

UnitedHealth Group Operating Margin TTM 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 it has grown.

UnitedHealth Group Dividend Chart

UnitedHealth Group Dividend Chart by YCharts

UnitedHealth has steadily increased its dividend since 2010, from $0.03 a year to $0.13 a quarter in 2010 to $0.16 a quarter in 2011.

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 1 means the company is not bringing in enough money to cover its interest expenses.

UnitedHealth Group Times Interest Earned (TTM) Chart

UnitedHealth Group Times Interest Earned (TTM) Chart by YCharts

UnitedHealth covers every dollar in interest expense with nearly $17 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.

UnitedHealth's payout ratio has historically been low. Even with its big move up, its payout ratios are still below 15%.

Another tool for better investing
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Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting. The Motley Fool owns shares of UnitedHealth Group. Motley Fool newsletter services have recommended buying shares of UnitedHealth Group, WellPoint, and Coventry Health Care. Motley Fool newsletter services have recommended creating a diagonal call position in UnitedHealth Group. 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.