There are many different things to consider before buying an ownership interest in a publicly traded company. These include the business model, valuation, and historical earnings growth. Another important consideration is the dividend. It's important to remember that from 1930 to 2012, dividends accounted for about 42% of the gains in the S&P 500.
Many investors pursue dividend-paying stocks to augment their returns with a nice income stream.
Companies in the telecom sector are some of the biggest dividend-paying companies around, and income investors often flock to them for their relatively high yields. Let's take a look at the dividends of AT&T, and see how they stack up in terms of size, growth, and sustainability.
The first and most obvious consideration when evaluating a company's dividend is the dividend yield, which represents the percentage of your investment that you'll receive back over the next 12 months at current share prices and dividend payouts.
AT&T currently yields a whopping 5.6%. This compares favorably with the dividend yield of its largest competitor Verizon, whose yield currently stands at 4.6%. Wireless competitors Sprint and T-Mobile US don't pay dividends at all.
It should also be mentioned that AT&T is currently the highest-yielding stock of the 30 components that make up the Dow Jones Industrial Average.
When analyzing a dividend, it's not all about the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation, as well as to show confidence from management in the company's outlook.
Over the last five years, AT&T has increased its dividend by an average of 2.3% each year. Its most recent increase was by 2.2%. While this is by no means an impressive level of dividend growth, it still slightly outpaces inflation, which currently sits at around 1.6%.
AT&T has increased its dividend every year for the last 30 years. For this reason, the company belongs to the S&P 500 Dividend Aristocrats, an elite group of companies who have increased their dividends for at least 25 years straight.
The high yield and strong history of dividend increases (although currently small) illustrate the commitment of AT&T when it comes to returning cash to shareholders.
Free cash flow payout ratio
While high dividend yields and strong dividend growth are nice, we need to make sure that the company in question can generate enough cash flow to cover its dividend payment. The free cash flow payout ratio tells us what percentage of the company's free cash flow is eaten up by dividend payments. Lower free cash flow payout ratios are better, as they leave more room available for future dividend increases or other uses of the capital.
Free cash flow is the cash flow a company generates in its operations minus capital expenditures.
Over the last 12 months, AT&T has paid out 70% of its free cash flow to shareholders in the form of dividend payments. This is slightly higher than its five-year average free cash flow payout ratio of 64%. These numbers are typical of a company that is in a mature industry.
While these numbers suggest that the dividend is not in any form of danger, we should note that in the company's most recent earnings release, management forecast free cash flow in 2014 to come in at around $11B.
We also know from the same earnings release that AT&T paid out a total of $9.7B in dividends over the last 12 months. If AT&T allocates the same amount of money to dividends this year as it did last year and its free cash flow forecast comes true, then its free cash flow payout ratio will balloon to 91%! This is extremely high, and doesn't leave much room for future dividend increases or other activities that might create value for shareholders.
Earnings per share growth forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth. This year, analysts expect AT&T to increase its earnings per share by 6%, followed by a 5% increase in 2015.
Earnings per share growth in the mid single-digit range should be enough to at least maintain the dividend going forward, as long as the company can effectively manage its capital expenditures.
AT&T stock currently offers a very attractive dividend yield, and management has shown its commitment to increasing the dividend every year over the last three decades. However, the increases lately have been very small, just barely outpacing inflation. With the current free cash flow forecast, we can expect to see the free cash flow payout ratio balloon to levels near 90%, making substantial increases in the near future a challenge. With earnings forecasts calling for mid single-digit earnings-per-share growth over the next couple of years, I think it is reasonable to expect the low single-digit dividend growth of AT&T to continue over the near-term.
David Schauber owns shares of AT&T. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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.