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 GlaxoSmithKline (NYS: GSK) stacks up. In this series, we consider four critical factors investors should examine in every dividend stock. We'll then tie it all together to look at whether GlaxoSmithKline is a dividend dynamo or a disaster in the making.
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.
GlaxoSmithKline yields 4.6%, considerably higher than the S&P 500's 2.1%.
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.
GlaxoSmithKline has a payout ratio of 101%, though on a free-cash-flow basis that figure falls to 72%.
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.
For a pharmaceutical maker, GlaxoSmithKline has a rather high debt-to-equity ratio of 183%, but its interest coverage rate is a safe 13 times.
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, GlaxoSmithKline's earnings per share have shrunk at an average annual rate of 7%, while its dividend has grown at a 7% rate.
The Foolish bottom line
GlaxoSmithKline exhibits a pretty reasonable dividend bill of health. It has a generous yield and manageable debt. Given its rather high payout ratio, however, dividend investors will want to keep an eye on earnings growth, which has stumbled recently, to ensure that the company will be able to continue increasing those payouts. If you're looking for some great dividend stocks, check out "Secure Your Future With 11 Rock-Solid Dividend Stocks," a special report from The Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about the 11 generous dividend payers -- simply click here.
At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned.You can follow him on Twitter@TMFDada.Motley Fool newsletter serviceshave recommended buying shares of GlaxoSmithKline. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not 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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