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Should you buy FTSE 100 giant Vodafone for its massive 7.5% dividend yield?

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Vodafone (LSE: VOD) shares currently sport a dividend yield of a colossal 7.5%. That’s one of the highest yields in the entire FTSE 100 index. But does that make the telecommunications giant a good dividend stock? Let’s take a closer look.

Slowing growth

When analysing dividend stocks, it’s important to look past a company’s headline yield and focus on factors such as business growth and dividend coverage. You want dividends that are sustainable in the long term.

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On the growth front, Vodafone appears to be struggling at present. For example, a trading update released this morning revealed that for the quarter ended 30 June, total group revenue fell 4.9% to €10.9bn due to a change in accounting standards and currency headwinds. That follows on from the 2.2% full-year revenue decline that the group reported for year ending 31 March. Declining revenue is not ideal from a dividend investing perspective, as it makes it harder to grow profits and dividends.

Dividend coverage (the ratio of earnings to dividends) also looks poor at Vodafone, meaning that the company may not be able to afford to pay its dividend in the future. Last year, the group reported adjusted earnings per share of 11.7 euro cents yet paid out dividends of 15.1 euro cents. That’s a ratio of just 0.8, which does not look sustainable. In general, analysts like to see a ratio of at least 1.5.

Turning to the stock’s valuation, I also think Vodafone shares look a little pricey at the moment. With analysts expecting earnings of 11 euro cents this year, the stock currently trades on a forward P/E of 18.3, which doesn’t offer much value, in my view. Weighing up all of these factors, I don’t think Vodafone is a top dividend stock right now, despite its high 7.5% yield. I think there are better alternatives in the FTSE 100.

Dividend growth champion 

One dividend stock that I do rate highly is insurance giant Prudential (LSE: PRU) which is the largest insurer in the FTSE 100. The stock’s yield is much lower than Vodafone’s, at 2.8%, but the dividend looks significantly more sustainable and the payout has been growing at a fast pace in recent years, which is always a good thing when you’re investing for income. 

Prudential certainly offers an attractive growth story, as the group generates 30% of its earnings from Asia. With an excellent reputation across many Asian countries, the group looks very well placed to capitalise on the strong demand for savings and insurance products that we’re likely to see in coming years from the fast-growing middle class across Asia. The insurer recently announced plans to tighten its focus on Asia by splitting itself into two companies, which makes sense strategically. 

Zooming in on PRU’s dividend, coverage looks healthy with earnings expected to cover dividends by a multiple of three this year. That means there’s a high margin of safety. It’s also worth noting that over the last five years, PRU has lifted its payout by an impressive 61% meaning the dividend has grown at a much higher rate than inflation.

Yet despite the compelling long-term growth story and the rock-solid dividend, Prudential shares look cheap at the moment, trading on a forward P/E of just 11.9. I believe that’s a very reasonable price to pay for a slice of this high-quality business.

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Edward Sheldon has no position in any shares mentioned. The Motley Fool UK has recommended Prudential. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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