Income investing is a tricky science. It's not enough to just look at the juiciest yields available, because the most generous yields aren't always married to solid dividend increases.
That's the case with AT&T (T -1.57%) right now. The nation's largest telecom sports a 5.6% dividend yield, making it the most generous payout on the Dow Jones Industrial Average (^DJI). Fellow telecom Verizon Communications (VZ -2.00%) grabs the second place in this internal Dow race, thanks to a 4.4% yield. No other Dow stock breaks the 4% benchmark.
So if all you're looking for is a great dividend yield today, then AT&T is your favorite Dow stock by far. But that isn't necessarily a great investing strategy.
You see, Ma Bell has nearly flatlined its dividend budget over the last five years, raising payouts by a minuscule 2.4% annually. Verizon isn't much better, growing dividends by 3.3% per year. These growth rates rank in the bottom third of the 30 Dow members.
The picture doesn't improve even if you zoom out a bit. AT&T has grown payouts by an average of 4.6% a year over the last decade, just ahead of Verizon's 3.1%. Again, both telecoms rank in the bottom third of all Dow stocks.
Actually, these companies sometimes spend more on dividend payouts than they really can afford.
Moreover, they don't have a ton of headroom to adopt more generous policies. AT&T spends 53% of its annual earnings on dividend payments, or 62% of free cash flow. Verizon uses 52% of earnings and 27% of free cash to fund dividend checks. The only good number here is Verizon's cash flow payout ratio. From every other angle, these companies are pushing the limits of reasonable dividend payouts. There just isn't much room to move, here.
Consider that IBM (IBM -1.48%) spends just 25% of its earnings and 30% of free cash flow on dividend payouts, and has increased its payouts by an average of 20% over the last decade. Suddenly, IBM's piddly 2.1% yield doesn't look so scary, because this dividend policy looks likely to keep up with share price gains.