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 Dow Chemical (NYS: DOW) 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 Dow 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.
Dow yields 4%, considerably higher than the S&P 500 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.
Dow has a moderate payout ratio of 54%.
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 Dow stacks up next to its peers:
DuPont (NYS: DD)
Eastman Chemical (NYS: EMN)
Huntsman (NYS: HUN)
Source: S&P Capital IQ.
Dow's debt position might seem burdensome, but we need to keep in mind that lots of debt isn't too unusual for the capital-intensive chemical industry. Of course, lots of debt can force dividend cuts during lean times; Dow needed to cut its dividend in 2009, whereas DuPont, Eastman, and Huntsman were OK. Should chemical demand fall because of a severe turn for the worse in the global economy, their respective payout ratios (today at 44%, 22%, and 28%) -- and, even more importantly, free cash flow payout ratios -- will become even more critical.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
5-Year Annual Earnings-Per-Share Growth
5-Year Dividend-Per-Share Growth
Source: S&P Capital IQ.
DuPont, Eastman Chemical, and Huntsman have all had a relatively easier time recovering from the economic downturn, though analysts do expect Dow's earnings recovery to continue over the next few years.
The Foolish bottom line
Dow exhibits a reasonable dividend bill of health. It has a big yield and a moderate payout ratio. Dividend investors may want to keep an eye on its debt burden should the economy hit a serious bump. But if the company is able to continue repairing its earnings as it's expected to, Dow could very well become a dividend dynamo once again. If you're looking for other great dividend stocks, check out "Secure Your Future With 9 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 the nine generous dividend payers.
At the time thisarticle was published Ilan Moscovitzdoesn't own shares of any company mentioned. You can follow him on Twitter, where he goes by@TMFDada. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
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