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 SeaDrill (NYS: TNH) , which yields 9%.
SeaDrill is a deep-sea driller owned largely by John Fredricksen, the founder and CEO who is also behind shipper Frontline (NYS: FRO) which has been hurting as of late. The company, along with competitors Transocean (NYS: RIG) and recent DryShips (NAS: DRYS) spinoff Ocean Rig (NAS: ORIG) , have been profiting handsomely from oil companies' exploration of the deep-sea floor. The companies have been doing well, although all took a big dip during the drilling moratorium in the Gulf of Mexico.
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 has it grown.
Since its IPO in 2010, SeaDrill's dividend has been volatile.
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.
SeaDrill covers every dollar of interest expense with nearly $10 of 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' 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. Periods where ratios are not meaningful are not displayed.
SeaDrill's payout ratio has been as volatile as its dividends.
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