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 CenturyLink (NYS: CTL) 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 CenturyLink 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.
CenturyLink yields a whopping 7.8%, considerably higher than the S&P 500's 2.1%.
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.
CenturyLink has a huge payout ratio of 192%, though that figure falls considerably to 59% on a free cash flow basis.
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 CenturyLink stacks up next to its peers:
Source: S&P Capital IQ. *Earnings before interest and taxes. **Earnings before interest, taxes, depreciation, and amortization.
Telco is a capital-intensive business, so each of these stocks has a high debt-to-equity ratio. Ordinarily, an interest coverage rate of two to three times would be worrisome, but since telcos often generate substantially more free cash flow than net income, it makes more sense to look at their interest coverage before depreciation on old assets. Interest coverage rates of four to six times are much more reasonable.
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
Source: S&P Capital IQ.
Again, earnings-per-share growth can sometimes provide a somewhat misleading picture for telcos, but the fact remains that particularly landline providers like CenturyLink and Frontier operate in steadily a declining industry. (CenturyLink's massive dividend growth comes off a low starting point.)
The Foolish bottom line
With a large debt load and a growth-poor industry, CenturyLink may not have all the features of a dividend dynamo, but it does have a high yield and moderate free cash flow payout ratio. So dividend investors will want to keep an eye on its free cash flow stability and growth to ensure that the company is able to continue making high payouts for years to come. If you're looking for some great dividend stocks, 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.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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