Arch Coal: Dividend Dynamo, or Blowup?

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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 Arch Coal (NYS: ACI) stacks up in four critical areas to determine whether it's a dividend dynamo or a disaster in the making.

1. Yield
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.

Arch Coal yields a moderate 2.2%, basically in line with the S&P 500 2.2%.

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.

Arch Coal has a payout ratio of 57%.

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 Arch Coal stacks up next to its peers.

Company

Debt-to-Equity Ratio

Interest Coverage

Arch Coal110%2 times
Patriot Coal (NYS: PCX) 57% N/A
James River Coal (NAS: JRCC) 127%1 time
Peabody Energy (NYS: BTU) 47%7 times

Source: S&P Capital IQ.

The coal and consumable-fuel industry tends to carry a fairly expensive debt burden.

4. Growth
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, Arch Coal as seen its earnings per share shrink at an annual rate of 11%, while its dividend has grown at a 16% rate.

The Foolish bottom line
Arch Coal exhibits a somewhat mixed dividend bill of health. It has a moderate yield and a reasonable payout ratio. But expensive interest payments and reduced earnings shouldn't be totally ignored. Although payouts are probably sustainable at current earnings rates, dividend investors will still want to keep an eye on the company's earnings to ensure that they're not too choppy and growing over the long term. To stay up to speed Arch Coal's progress, or that of any other stock, add it to your stock watchlist. If you don't have one yet, you can create a free, personalized watchist of your favorite stocks.

At the time this article was published Ilan Moscovitzdoesn't own shares of any company mentioned.You can follow him on Twitter, where he goes by@TMFDada. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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