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 Caterpillar (NYS: CAT) , which yields 2.1%.
Caterpillar makes large construction equipment. The company reported stellar operating results in the third quarter, with a 58% increase in earnings over the previous year and 55% increase in Asia-Pacific revenue growth. Competitors PACCAR (NYS: PCAR) and Deere (NYS: DE) also posted strong quarters while Cummins (NYS: CMI) was the one of the few competitors that did not meet expectations. The construction-equipment industry is very cyclical, and Caterpillar's stock tends to move with the economy.
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.
Caterpillar's dividend has been steadily rising since 2007.
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.
Caterpillar covers every $1 in interest expense with $6 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.
Caterpillar's payout ratios have been more volatilve than I would expect; however, its free cash flow payout ratio has been relatively stable at under 50% since 2009.
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