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.
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.
Arch Coal yields 3.1%, considerably higher than the S&P 500's 2%.
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.
Arch Coal has a moderate payout ratio of 57%.
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.
Let's examine how Arch Coal stacks up next to its peers:
Patriot Coal (NYS: PCX)
James River Coal
Peabody Energy (NYS: BTU)
Source: S&P Capital IQ.
Coal extraction is a fairly capital-intensive business -- hence the high debt burdens. Still, it's a bit disconcerting to see such low interest coverage in a somewhat cyclical commodities business. Patriot Coal has even generated operating losses for the past two fiscal years. That said, neither Arch Coal nor the other dividend payer in the group, Peabody, was forced to cut its dividend during the financial crisis despite some pretty large earnings swings.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
James River Coal
Source: S&P Capital IQ. *Negative earnings. **Negative earnings in comparison period.
Whereas Peabody's earnings have raced past their pre-recession levels, Arch Coal's earnings decline has stabilized, but they haven't begun to reapproach their pre-downturn levels. And Patriot is still mired in losses.
The Foolish bottom line
Despite its sizable yield and moderate payout ratio, Arch Coal probably isn't a dividend dynamo due to the cyclicality of its business, the difficulty it's had producing earnings growth, and its low interest coverage. However, if you're looking for some great dividend stocks, I suggest you 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 these 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. 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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