Today I’ll be taking a closer look at mobile telecoms giant Vodafone (LSE: VOD) and revealing why the shares could be heading for a massive correction. Later this month we expect the UK’s largest mobile network to report its annual results for the financial year ending 31 March. So maybe it’s a good time to discuss the risks involved for new investors in this successful FTSE 100 blue-chip.

Premium rating

The medium-term outlook looks pretty mixed for Vodafone. Analysts expect the company to report a 10% fall in earnings for the year to March 2016, followed by an impressive 22% rebound next year, and a further 29% improvement pencilled-in for fiscal 2018. So excellent growth is predicted for this year and next, but does this growth come at a price?

Vodafone shares currently trade on a forward price-to-earnings (P/E) ratio of 44 for fiscal 2016, falling to 36, then 28, for 2017 and 2018. Comparing these numbers to the likes of BT for example, which trades on a P/E of 14, makes us realise just how expensive Vodafone has become. Every stock has its own ‘normal’ range of P/E ratings, but even here we see that up until 2014, Vodafone was trading on earnings multiples of between 10 and 12.

The only way to justify a premium rating is if growth continues at 20% to 30% year after year. For a £60bn goliath like Vodafone, that would be very difficult to sustain, and eventually lead to a massive share price correction. The bigger the expectation, the bigger the disappointment.

Dividends exposed

For most investors, Vodafone has always been an income play. A safe, solid, reliable British company that will pay out chunky dividends to its shareholders each and every year. That’s great, but what if the company’s earnings can’t cover the promised dividend payouts? Believe it or not, we’ve already arrived at that situation with Vodafone.

Dividends are forecast at 11.45p for the year just ended to 30 March, followed by 11.41p and 11.65p for 2017 and 2018, respectively. But the company is expected to report earnings per share of only 5.02p, 6.12p and 7.87p for the same three years. Hence, the company’s earnings won’t be able to cover the dividend payout, and the company will dip into its cash reserves, or have to cut its dividend, which in turn will lead to a massive sell-off. Vodafone has pledged to maintain its dividend, but how long can this be sustained without significant growth in earnings?

Whether or not Vodafone suffers a market correction remains to be seen. Even if not, the points covered here today are worth bearing in mind when looking at investing in companies with high P/E ratios, or little or no dividend coverage. Sooner or later the market will catch up and the shares will tumble. It’s happened before, and it’ll happen again!

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Bilaal Mohamed has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.