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 1.7%.
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 has raised its dividend four times in the past five years to where it now rests at $0.46 per quarter.
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 one means the company is not bringing in enough money to cover its interest expenses.
Caterpillar covers every $1 in interest expense with over $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 ratio spiked with the financial crisis but has since come down to near 30%.
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 Caterpillar to My Watchlist.
For more dividend stock ideas, get The Motley Fool's free report, "11 Rock-Solid Dividend Stocks."
At the time thisarticle was published Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.