Are These Dividends Going to Be Around for Long?

Let's face it: Dividends aren't all that sexy. While rule-breaking stocks may zoom up or down 100% in a year's time, dividend stocks are the tortoises to the hares.

But if anyone had a doubt about the power of dividends, they need only read Jeremy Siegel's The Future for Investors, where he writes: "Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run."

An important metric for dividends
The telecom sector, in particular, is a gold mine for dividend investors. The average yield in this industry is just below 3%.

Knowing how important dividends can be, we investors also can't forget to examine how sustainable a company's dividend is. One of the most popular metrics for doing so is the earnings payout ratio, which essentially measures the amount of earnings a company dedicates to paying out dividends. As the theory goes, the lower the payout ratio is, the more sustainable the dividend is.

The following table includes seven popular telecom stocks -- including Nokia, a play on mobile phones that also has a telecom equipment division -- along with their payout ratios.

Source: Yahoo! Finance. Values as of June 4.

In their book Million Dollar Portfolio, David and Tom Gardner suggest that you should hold only stocks with a payout ratio of less than 65%. Clearly, this benchmark would make the cautious Fool worry about the sustainability of dividends from the likes of Frontier, Windstream, Century Link, Telefonica, and Verizon.

But wait -- there's more!
This is where things get tricky. Because earnings are reported using the accrual method, companies may not yet have collected all of the money that they say they've earned. Things like accounts receivable and payable, depreciation, and goodwill are included in earnings -- and they don't immediately affect the amount of money a company has in the bank.

The good news is that there is a way to see how much money a company has put in the bank: free cash flow. This number is very important -- some Fools would say more important -- in evaluating a company's dividend sustainability. Ultimately, dividends are paid from free cash flow, not from earnings.

Check out the free cash flow payout ratio for these companies, and the story changes considerably.

All information from Yahoo! Finance.

Wow! That really changes things. Using earnings to calculate payout ratio, we had just two safe dividends earlier in the article. When we dove into free cash flow -- which, again, is what dividends are paid from -- we see that though there are still only two safe dividends, many of them are much closer to "safety" than they were before.

How can this be?
It's no secret that capital expenditures can be enormous for telecoms, and when a company needs to build out or improve upon its existing infrastructure, cash flow can disappear.

Sometimes this is just a short-term problem, but other times, it's a serious cause for concern. Let's look at these companies' average annual free cash flow over the past three years, divided by their most recent year's dividends paid.

This view can give you better perspective on how companies' cash flow is performing over a longer period of time, thus minimizing any effects of recent large capital expenses that could be lumped into a shorter period. CentryLink and Frontier, for example, have both made major acquisitions in recent years, far increasing their revenues, cash flow, and shares outstanding. For that reason, historical cash flow won't match well with higher recent payouts. In these two telecoms' cases, more recent payout ratios, such as the one in the second table, are probably the best indicator of their ability to continue paying out their high yields.

Foolish takeaway
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