Not all dividends are created equal. Here, we'll do a top-to-bottom analysis of a given company to understand the quality of its dividend and how that's changed over the past five years.
The company we're looking at today is Frontier Communications
Frontier is a rural telecommunications firm, though it recently expanded into the wireless game by signing a reseller agreement with AT&T
To evaluate the quality of a dividend, the first thing to consider is whether the company has paid a dividend consistently over the past five years, and, if so, how much has it grown.
Frontier's dividend had been stable at $0.25 per share until the merger in 2010, at which point the company lowered its dividend to $0.1875 per share. Frontier has mandated levels of capital expenditures for the next year, at which point it can use its excess cash flow to increase the dividend or pay down debt.
To understand how safe a dividend is, we use three crucial tools, the first of which is:
- The interest coverage ratio, or the number of times interest is earned, which is calculated by earnings before interest and taxes, divided by interest expense. The interest coverage ratio measures a company's ability to pay the interest on its debt. A ratio less than 1.5 is questionable; a number less than 1 means the company is not bringing in enough money to cover its interest expenses.
At 1.36, Frontier's interest coverage ratio is worrisome, though it should begin rising once the company's mandatory capital investments go down next year.
The other tools we use to evaluate the safety of a dividend are:
- The EPS payout ratio, or dividends per share divided by earnings per share. The EPS payout ratio measures the percentage of earnings that go toward paying the dividend. A ratio greater than 80% is worrisome.
- The FCF payout ratio, or dividends per share divided by free cash flow per share. Earnings alone don't always paint a complete picture of a business's health. The FCF payout ratio measures the percent of free cash flow devoted toward paying the dividend. Again, a ratio greater than 80% could be a red flag.
Source: S&P Capital IQ.
With the merger, Frontier's earnings payout ratio sky rocketed as it acquired a huge amount of assets, which come with large depreciation charges. The depreciation charges are not reflective of the underlying business, however, and as such, the company's free cash flow payout ratio tells the real story. This past quarter, the payout ratio finally surpassed the 100% mark.
Source: S&P Capital IQ.
With high payout ratios, there are some alternatives in the industry, though none with as high of a yield. Coming closest is France Telecom
Another tool for better investing
Most investors don't keep tabs on their companies. That's a mistake. If you take the time to read past the headlines and crack a filing now and then, you're in a much better position to spot potential trouble early. We can help you keep tabs on your companies with My Watchlist, our free, personalized stock-tracking service.
Follow Dan Dzombak on Twitter at @DanDzombak to check out his musings and see what articles he finds interesting. 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.