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.
First and foremost, dividend investors like a large 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 9.1% -- certainly worth further investigation.
2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends to the amount it generates. 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.
Telefonica's payout ratio is a moderate 61%.
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 5 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: Capital IQ, a division of Standard & Poor's.
Telefonica carries a fairly significant amount of leverage.
A large dividend is nice; a large growing dividend is even better. We also want to see earnings growth to support a growing dividend.
Over the past three years, Telefonica's earnings have grown at an annual rate of 19%, while its dividend has grown at a rate of 23%.
The Foolish bottom line
Telefonica exhibits a fairly clean dividend bill of health. Despite its whopping yield, the payout ratio is quite moderate. But it's worth keeping an eye on the company's significant leverage, which would become a concern should its massive earnings growth reverse.
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Ilan Moscovitz doesn't own shares of any companies mentioned. You can follow him on Twitter at @TMFDada. The Motley Fool owns shares of Telefonica. Motley Fool newsletter services have recommended buying shares of Vodafone Group and France Telecom. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.