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 Frontier Communications (NAS: FTR) 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 Frontier 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.
Frontier yields a whopping 8.7%, considerably higher than the S&P's 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 499%. But the company generates considerably more free cash flow than net income; on a free cash flow basis, the payout ratio falls to 100%.
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.
Frontier has a debt-to-equity ratio of 186% and an interest coverage rate of two times. That seems a bit severe, but it's also in-line with its peers. After all, landlines are a capital-intensive and stable -- if declining -- business. (Revenue shrank another 5% last quarter.)
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 28%, while its dividend has shrunk at a 6% rate. Free cash flow, however, has been much more positive over that period.
The Foolish bottom line
Frontier exhibits a somewhat mixed dividend bill of health. It has an enormously tempting yield, but 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 a particularly close eye on earnings and cash flow stability to ensure that those payouts keep coming. If you're looking for some great dividend stocks, I also 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 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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