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.

Let's examine how Telefonica (NYSE: TEF) 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 Telefonica is 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 9.7%, 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.

Telefonica has a payout ratio far above 100%, though that's largely a result of the European financial crisis, losses on investment sales, and restructuring charges. As of last summer, the figure was closer to 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 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 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. Like many telcos, Telefonica has struggled to hang on to earnings growth in recent years, though their dividends have so far remained protected:

Source: S&P Capital IQ. *Negative earnings in comparison period.

The Foolish bottom line
Telefonica is coping with the ongoing European economic crisis. With such a massive yield, it could very well be a dividend dynamo, albeit a slightly higher-risk one. If you're looking for other 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.