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 (NYSE: FTR), which yields 14.2%.

Frontier is a rural telecommunications firm, though it recently expanded into the wireless game by signing a reseller agreement with AT&T (NYSE: T) Mobility. The company made a huge move in 2010 to buy Verizon's (NYSE: VZ) rural wire-line business, greatly expanding the size of the firm. Competitor CenturyLink (NYSE: CTL) made a similar move, buying Embarq and Qwest. The move added a significant amount of debt to the company's balance sheet, but Frontier believes the economies of scale it will be able to achieve will make it worth it. The market has grown worried about Frontier's debt load and its slowly declining revenues, and has punished the stock recently.

Frontier Communications Corporation Total Return Price Chart

Frontier Communications Corporation Total Return Price Chart by YCharts.

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 Communications Corporation Dividend Chart

Frontier Communications Corporation Dividend Chart by YCharts.

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.

Immediate safety
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.
Frontier Communications Corporation Times Interest Earned (TTM) Chart

Frontier Communications Corporation Times Interest Earned (TTM) Chart by YCharts.

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 (NYSE: FTE), with an 11.2% trailing yield and a 47% free cash flow payout ratio. Next up is Windstream (NYSE: WIN), with an 8.6% trailing yield and 77% payout ratio. Last but not least is Vodafone Group (NYSE: VOD), with a 5.2% trailing yield and a 67% payout ratio. However, Vodafone's recent dividend payment from its partially owned subsidiary Verizon Wireless should contribute to larger dividends in the future.

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.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.