Telefonica: Dividend Dynamo or the Next Blowup?

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.

In the latest edition of this series, let's examine how Telefonica (NYS: TEF) stacks up in four critical areas to determine whether it's a dividend dynamo or a disaster in the making.

1. Yield
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.

Telefonica yields a massive 10.1%, considerably better than the S&P 500's 2.2%.

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.

Telefonica has a moderately high payout ratio of 72%.

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 Telefonica stacks up next to its peers:

Source: S&P Capital IQ.

Telefonica has an incredibly high debt-to-equity ratio, though the company's operating earnings are currently high enough to support its interest payments.

4. Growth
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.

Over the past five years, Telefonica's earnings per share have grown at an annual rate of 16%, while its dividend has grown at a 23% rate.

The Foolish bottom line
Telefonica exhibits a fairly clean dividend bill of health. Despite its whopping yield, the payout ratio is quite moderate. But it's worth keeping an eye on the company's significant leverage, which would become a concern should its massive earnings growth reverse, particularly in light of the ongoing European debt crisis. To stay up to speed on Telefonica's progress, or on any other stock, add it to your stock watchlist. If you don't have one yet, you can create a free, personalized watchlist of your favorite stocks by clicking here.

At the time thisarticle was published Ilan Moscovitz doesn't own shares of any company mentioned. You can follow him on Twitter @TMFDada. The Motley Fool owns shares of Telefonica. Motley Fool newsletter services have recommended buying shares of France Telecom and Vodafone Group. 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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