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Investors who shy away from stocks with too high a dividend payout ratio are missing the call of high-yielding telecommunications stocks. With many investors' increased interest in high-yielding stocks, a natural concern is how well companies are able to pay and grow their dividends. One of the measures of the sustainability of a company's dividend is its payout ratio, defined as the ratio of a company's dividend payments to net earnings. Lower ratios are seen as healthier because they allow more cash to be used for operating activities and corporate expansion, as well as providing a margin of safety if earnings decrease.

Higher ratios, of course, allow for higher dividends sought by income investors. Very high dividend payout ratios, particularly those over 100%, are viewed as danger signs that the company's business prospects are fading, earnings are decreasing, dividends are in danger of being cut, etc. In some industries, however, net earnings are a poor measure of the ability to pay dividends, and investors should not be fooled in these cases. The telecommunications industry contains many stocks with payout ratios over 100% that actually have quite safe dividends.

AT&T (NYSE:T), for example, had 2011 net earnings of $0.66 per share. It paid out a dividend of $1.76, for a nominal payout ratio of 267%. Normally such a high payout ratio is viewed as an extreme sign of danger. In this case, however, the dividend is completely supported. Free cash flow is a measure of a company's profitability that adds back into earnings such non-cash expenses as depreciation and amortization. Free cash flow also generally adds back in interest expenses and capital expenditures, but since these are necessary expenses from a stockholder's point of view, I prefer to use Warren Buffett's concept of owner earnings.

Owner earnings can be thought of as the cash generated by a company that is available for distribution to the company's owners. Owner earnings can be calculated as net income plus non cash charges such as depreciation and amortization, less the capital expenditures necessary to maintain the business. AT&T had depletion, depreciation, and amortization costs of $18.4 billion in 2011, and so AT&T owner earnings in 2011 is about $22.3 billion, or $3.75 per share. So AT&T pays a dividend equal to 47% of its owner earnings, or a much more sustainable rate.

Other companies in the telecommunications sector have similarly misleading dividend payout ratios. Verizon (NYSE:VZ) has a reported dividend payout ratio of 235% based on earnings of $0.85 per share in 2011 and a dividend of $2.00. Verizon had net earnings of $2.4 billion after depletion, depreciation, and amortization expenses of $16.5 billion. Adding those to net earnings gives owner earnings of $18.9 billion, or $6.66 per share. This yields a dividend payout ratio to owner earnings of 30%. CenturyLink (NYSE:CTL) has a reported dividend payout ratio of 163%, but its dividend as a percentage of owner's earnings is 46%. In this case, since CenturyLink has not reported 4th quarter earnings, I used the last four quarters that have been recorded to make the calculation.

This same phenomenon holds true for foreign telecommunications companies as well, though it is somewhat less predictable because of dividend policies and changing foreign exchange rates. One example is Telefonica (NYSE:TEF), a company that is based in Spain but receives about 35% of its revenues in Spain, just under 25% in the rest of Europe, and 40% in Latin America. Telefonica paid dividends of $2.05 over the last 12 months against reported earnings of $2.26 per share in the last four quarters, for a 91% payout ratio. Adding depletion, depreciation, and amortization to reported net income gives owner earnings of $4.40 per share, and dividends are just 46% of that.

Telecommunications stocks are a great example for illustrating the importance of looking beyond net income in evaluating a company's prospects for paying and expanding a dividend. Other analysts may use EBITDA (earnings before interest, taxes, depreciation, and amortization) or free cash flow, but owner earnings is a superior metric to evaluate a company's ability to pay out a dividend while continuing to fund expansion (via capital expenditures) and while paying interest to bond holders. Each metric takes into account a company's non-cash expenditures, and is a starting place but not a substitute for studying the company's income statement.

Source: Misleading Dividend Payout Ratios In Telecommunications Stocks