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.
Vector yields a whopping 8.9%, considerably higher than the S&P 500's 2%. That's also much higher than the other major tobacco producers. Of Altria (NYS: MO) , Philip Morris International (NYS: PM) , and Reynolds (NYS: RAI) , Altria comes the closest to Vector's dividend, still clocking in well below at a 5.5% yield.
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.
Vector has a massive payout ratio of 167%. Tobacco isn't a particularly capital-intensive industry, so it's normal for companies to have high payout ratios. That said, it's still unusual to have a payout ratio above 100%. Altria, Philip Morris, and Reynolds all generate enough earnings to cover their payouts.
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 Vector stacks up next to its peers:
Philip Morris International
Source: S&P Capital IQ.
Vector doesn't have a debt-to-equity ratio because it has negative equity. Its operating income barely covers interest payments. Altria and Philip Morris are able to carry substantial debt-to-equity ratios because tobacco-making is such a stable business, but their operating income covers their interest payments comfortably enough.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Philip Morris International
Source: S&P Capital IQ. *Three-year.
Focused on the shrinking U.S. tobacco market, Altria's and Reynolds' earnings growth has lagged Philip Morris International's. PMI, the spinoff of Altria's international division, saw a slight 1.7% volume growth last quarter with improving operational leverage and share buybacks leading to 19% earnings-per-share growth. But despite its domestic focus, Vector has also managed to turn in impressive overall earnings growth over the past several years.
The Foolish bottom line
So is Vector a dividend dynamo or a blowup? While a high yield in itself isn't always cause for alarm, and Vector has had strong growth over the past few years, its enormous payout ratio and debt burden are quite worrisome to me. It's not inconceivable that its earnings will catch up with its dividend before it is forced to make a cut, but the company is pushing its dividend-paying ability. However, if you're looking for some safe dividends, 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.The Motley Fool owns shares of Philip Morris International and Altria Group.Motley Fool newsletter serviceshave recommended buying shares of Philip Morris International. 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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