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.
Pepco yields 5.5%, 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.
Pepco has a slightly high payout ratio of 90%.
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 Pepco stacks up next to its peers:
CenterPoint Energy (NYS: CNP)
Wisconsin Energy (NYS: WEC)
Source: S&P Capital IQ.
Electric generation is both a capital-intensive and stable business -- hence the high debt burdens. One point worth mentioning: Despite carrying the highest debt-to-equity ratio of the bunch, CenterPoint (which yields 4.3%) has actually done a lot to reduce its debt burden over the past several years.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Source: S&P Capital IQ.
Electricity generation can be a sleepy business as far as earnings growth is concerned, so while growth would be nice, these numbers aren't exactly out of the ordinary. However, Wisconsin Energy is a standout in the earnings growth department, which it's managed to do without resorting to taking on a great deal of extra debt by simply improving its return on assets over a stretch of time.
The Foolish bottom line
So is Pepco a dividend dynamo? It's a bit of a mixed story. The company does have a truly large dividend yield, a more-or-less reasonable payout ratio, and a manageable debt burden. Still, given its high payout ratio, dividend investors will want to keep an eye on the company's earnings growth to ensure that it's able to keep growing those dividends in the future.
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.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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