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.
Frontier yields a whopping 13.3%, considerably higher than the S&P'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.
Frontier has an enormous payout ratio of 487%. But the company generates considerably more free cash flow than net income; on a free cash flow basis, the payout ratio falls to 113%.
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 Frontier stacks up next to its peers:
CenturyLink (NYS: CTL)
Windstream (NYS: WIN)
AT&T (NYS: T)
Source: S&P Capital IQ.
Frontier has a high debt burden, though it's important to keep in mind that telecommunications is a capital-intensive business that often relies on tons of debt.
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, Frontier's earnings per share have shrunk at an annual rate of 27%, while its dividend has shrunk at a 6% rate. Free cash flow, however, has been much more stable over that period.
The Foolish bottom line
Frontier exhibits a somewhat mixed dividend bill of health. It has an enormously tempting yield, in large part because it pays out a significant portion of its profits in dividends and wireline communications is a shrinking business. Given these factors, in addition to its significant leverage, dividend investors will want to keep an eye on earnings and cash flow stability to ensure that those payouts keep coming. To stay up to speed on Frontier's progress, add it to your stock watchlist. If you don't have one yet, you can create a free, personalized watchlist of your favorite stocks.
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. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't 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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