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 see how that's changed over the past five years.
The company we're looking at today is ABB (NYS: ABB) , which yields 4%.
ABB is in the power and automation business. In the power business its main competitors are General Electric (NYS: GE) and Siemens (NYS: SE) , while in the automation business its main compeitors are Honeywell (NYS: HON) and Rockwell Automation (NYS: ROK) . Both industries are very tied to the economy as has ABB's stock.
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.
ABB's annual dividend has been stable and growing.
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.
ABB generates nearly $22 for every dollar in interest expense.
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.
ABB's earnings payout ratio has remained steady while its free cash flow payout ratio has been all over the place.
Another tool for better investing
Most investors don't keep tabs on their companies. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. We can help you keep tabs on your companies with My Watchlist, our free, personalized stock-tracking service.
Add ABB to My Watchlist.
At the time thisarticle was published FollowDan Dzombakon Twitter at@DanDzombakto check out his musings and see what articles he finds interesting. 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.