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.
Let's examine how AK Steel (NYS: AKS) stacks up. In this series, we consider four critical factors investors should examine in every dividend stock. We'll then tie it all together to look at whether AK Steel is a dividend dynamo or a disaster in the making.
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.
AK Steel's 2.8% is quite a bit higher than the S&P 500's 1.9%.
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.
AK Steel doesn't have a ratio because it's taken losses over the past three years.
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.
AK Steel has a debt-to-equity ratio of 239% and an interest coverage rate of 1.4 times. This is a significant amount of debt, but it's not unusual for the steel industry, and the interest coverage rate may be temporarily low because of weak operating results.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Despite negative earnings, AK Steel has held its annual dividend at $0.20 since it was reinstated in 2008.
The Foolish bottom line
AK Steel exhibits a troubling dividend bill of health, but that doesn't necessarily mean a cut is imminent. The company could continue paying out its dividend until earnings pick up again by borrowing money, liquidating cash or other assets, or selling shares, though that's ultimately unsustainable.
Dividend investors interested in AK Steel should keep their eyes on when the company will be able to return to profitability. According to analysts, the company should earn enough in 2012 to cover its dividend more than twice over ($0.52), and excluding pension charges there's been an improvement in recent quarters. We'll have to see how things look when AK reports first-quarter earnings later this month.
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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.
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