Purchasing a stock that pays a dividend has a certain allure to it. It's nice to own something and get paid to own it. And because it's a stock, there's also a chance for the price to increase, further compounding the return on investment.
However, a stock can still go down, and a dividend can get cut -- something AT&T (T 0.19%) investors know all too well.
AT&T's dividend yield is alarmingly high right now
Currently, AT&T sports a high 7.4% dividend yield, which means the company will pay an estimated 7.4% of its stock price to shareholders each year. This number constantly fluctuates because it is calculated using the annual dividend payout divided by the stock price.
The yield rises if the dividend goes up and the stock price stays the same. The opposite is also true. However, when a business begins to falter, its stock price can plunge, and management may maintain the dividend payout to avoid spooking shareholders. This scenario happened to AT&T earlier this year, as AT&T's annual dividend payout was $2.08 while the stock was at $24 -- a nearly 9% yield. Typically, any dividend yield over 5% should be a red flag for investors because anything greater than that is either unsustainable or indicates investors believe there are serious problems in the underlying business.
Investors' fears came true after AT&T cut its dividend nearly in half following its April spinoff of Warner Bros. Discovery. Additionally, the stock is down about 20% this year.
Should investors be worried about AT&T's yield still being above that 5% threshold?
It's all about the payout ratio, and cash flows don't lie
The dividend payout ratio, the percentage of profits paid out in the form of dividends, can inform investors whether the dividend is safe.
Data by YCharts.
Over the past year, AT&T reached a high payout ratio but never climbed to an unsustainable level. As it sits right now, the telecom major should be able to sustain its dividend if it maintains its profits. But that isn't the complete picture of the company.
AT&T is a highly leveraged business, with nearly $130 billion of debt versus $4 billion in cash on the balance sheet. As you might expect, the interest payments on $130 billion are quite high -- the company paid $1.5 billion in interest expenses alone in Q2. AT&T also has to repay the debt, creating a cash crunch.
Profits aren't always an accurate picture of a business's cash flows, as they can be massaged to convey a specific message, which is why using a free cash flow-derived payout ratio can be more accurate.
When looking at AT&T's free cash flow dividend payout ratio, it's not a pretty picture. In Q2, AT&T only produced $1.4 billion in free cash flow yet paid out $2.1 billion in dividends -- a payout ratio of 151%. As a result, investors should be concerned and potentially expect another cut compared to last year's 74.1% payout ratio with a higher dividend yield.
Revenue isn't growing very fast for AT&T anymore: Q2 saw revenue increase 2% over last year. Management also expects low-single-digit growth this year, so this trend likely won't change soon. With low revenue growth, investors can't count on the top line to deliver the cash AT&T needs to sustain a healthy dividend payout.
The 7.4% yield is tempting for investors, but I think this stock is too dangerous to own. There are much better companies that may not have as big a yield but are still growing. Those businesses will return much better results over the long term, and investors should focus on them instead.
