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.
Rio Tinto yields 2.5%, a bit 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.
Rio Tinto has a moderate payout ratio of 38%.
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 five 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 Rio Tinto stacks up next to its peers:
BHP Billiton (NYS: BHP)
Vale (NYS: VALE)
Alcoa (NYS: AA)
Source: S&P Capital IQ.
Each of these mining companies carries a reasonably modest amount of debt. What's interesting here, though, is just how much less burdensome the debts of Rio, BHP, and Vale are compared to Alcoa's. What accounts for the difference? Their returns on equity are so much higher, ranging from an uncharacteristically low 11% for Rio to 38% for BHP, versus just 5% for Alcoa. The three are much more diversified. The markets for bauxite, copper, gold (Rio), oil, gas, copper, silver (BHP), and fertilizer, nickel, and copper (Vale) are on the whole much better right now than for aluminum.
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.
Rio Tinto's most recent quarter was a disaster because of an enormous noncash charge writing down its Canadian aluminum assets. The company's operating income has actually grown by an annualized 18% over the past five years.
The Foolish bottom line
So is Rio a dividend dynamo? Perhaps. It's important to remember that commodity prices can go up as well as down. Moreover, its yield, though substantial, isn't quite in "dynamo" territory. That being said, with a decent yield, a modest payout ratio, a manageable debt burden, and growth to boot, Rio could very well be a strong dividend stock. If you're looking for some other 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 Moscovitz doesn't own shares of any company mentioned. You can follow him on Twitter @TMFDada. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.