A couple of weeks ago, AT&T (NYSE:T) announced fourth-quarter earnings of 63 cents per share, which met analyst expectations. AT&T continues to trade with a dividend yield of around 5.5%. While AT&T's earnings of 63 cents per share are clearly higher than its 48 cents per share dividend, a deeper analysis is required to determine the sustainability of the telecom giant’s dividend.

The first method of determining AT&T’s dividend sustainability is to examine the payout ratio or the dividend divided by the earnings.  On a quarterly basis, AT&T’s payout ratio was 76% in the fourth quarter, which is higher than 63% in the third quarter.  Despite the negative connotation of a much higher payout ratio (less room for expansion) in the quarter, AT&T's payout ratio on a trailing twelve-month basis dropped from 72% in the third quarter to 70% in the fourth quarter.  This demonstrates that despite increasing the dividend last month, AT&T has more room than it appears to cover its dividend.

Another metric to focus on for dividend sustainability is return on equity. In theory, if the company’s return on equity is higher than its price to book value multiplied by its dividend yield, AT&T will be able to cover its dividends without eating into shareholder equity and compromising its credit rating. For AT&T, a return on equity of over 9.5% is required to maintain shareholder equity. In the fourth quarter, AT&T’s return on equity was over 13%, which clearly covers this threshold.

Free cash is another good metric of dividend sustainability. A company that has free cash flow less than dividends will likely need to issue debt, stock, or turn to alternative types of financing to maintain the dividend (or cut the dividend).  In the past two quarters, AT&T’s twelve-month dividend obligation has increased from $9.8 billion to $11.8 billion. Fortunately, AT&T’s trailing twelve-month free cash flow has increased from $12.5 billion to $16.4 billion. By having its free cash flow growth outpace its dividend growth, AT&T is more capable of generating the cash required to cover dividend obligations.

Looking forward, analysts are expecting earnings per share to range from 68 cents to 79 cents on a quarterly basis through the end of 2018. Analysts also appear to be more optimistic about forward earnings than in the previous quarter. Our internal spreadsheet calculator estimates that AT&T will raise the dividend to 50 cents per share in January 2017.