In my entry criteria, I typically focus on companies that have a sustainable dividend payment. A sustainable dividend payment is one where the ratio of dividends to earnings per share in a given year does not exceed 60%. In addition, I also focus on the price/earnings ratio, which is a ratio of the stock price over the annual earnings per share.
Astute readers would thus notice that earnings per share is a key component of my analysis, as it is part of the P/E and dividend payout ratio calculations. For my analysis of earnings per share, I tend to focus on income from continuing operations. These generate earnings from sources, which have a high chance of recurring for many years. Many companies however generate one time gains or losses which directly affect earnings per share. As a result, I tend to “normalize” this key indicator, in order to have an objective analysis.
In a previous article, I expressed my concerns over the sustainability of AT&T's and other telecom companies' dividend payments. On the surface however, it appeared that AT&T (T) earned $3.35/share in 2010. This represents the highest EPS amount ever. In addition, the P/E ratio seems to be 8.50, while the dividend payout ratio is 51.30%. When you drill further into the earnings figures and switch to a quarterly view however, one would notice that the company earned $1.95 in the third quarter of 2010. This was much higher than the $0.54/share earned in the third quarter of 2009, and much higher than the $0.68/share earned in the second quarter of 2010. I researched the issue, and found this press release from the company’s website:
Third-quarter 2010 net income attributable to AT&T totaled $12.3 billion, or $2.08 per diluted share, including $1.53 in one-time gains from a previously disclosed tax settlement and the sale of Sterling Commerce.
This shows that the company earned $1.53/share from a one-time gain. In addition, $0.13/share came from discontinued operations. This leads to a normalized EPS of $0.42 for the quarter, which decreases earnings per share for 2010 to $1.69/share. As a result, the dividend payout ratio looks closer to 100%, whereas the P/E ratio looks close to 16.70. Even if AT&T manages to earn $2.40/share in 2011, its dividend coverage is still unsustainable at 72%. Check my analysis of the stock.
For Coca-Cola (KO) a large portion of the EPS for 2010 investors are seeing is coming from a gain related to the purchase of CCE North American Operations. Most investors see annual EPS of 5.06/share in 2010, which makes the P/E 13 and the DPR to be 37.20%. Zooming in on the EPS for the fourth quarter of 2010, one could see that the firm had EPS of 2.46/share, which was higher than the Q4 2009 earnings of $0.66/share and the Q3 2010 earnings of $0.88/share.
From the company's press release:
Fourth quarter reported EPS was $2.46, with comparable EPS at $0.72, up 9%, including a $0.02 dilutive impact to comparable EPS as a result of the Coca-Cola Enterprises transaction. Full-year reported EPS was $5.06, with comparable EPS at $3.49, up 14%.
Here's more from the press release:
As required by accounting standards, the Company revalued its 33% ownership of CCE to fair value at the closing date of the transaction to acquire CCE's North American operations, resulting in a $5.0 billion one-time non-cash gain in the fourth quarter of 2010.
So to summarize, I used EPS of $3.83 in my analysis of Coca-Cola, rather than $5.06 since the extra $1.23 dollars/share came from basically writing up the company's previous initial partial investment in the bottling plans when it acquired them in full. These are one time earnings events, so they should not be taken into consideration. This increased the P/E ratio to 17.30 and the dividend payout ratio to 49.10%.
As a result, I would stay away from AT&T (T), despite its mouth watering yield of 6%. I am wary of high-yielding stocks, particularly from the telecom sectors. I would also prefer buying PepsiCo (NYSE:PEP) stock over Coca-Cola (KO), given the fact that PepsiCo is cheaper than Coke.
Disclosure: Long KO and PEP