Dividend paying stocks like Allison Transmission Holdings, Inc. (NYSE:ALSN) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.
With a 1.3% yield and a seven-year payment history, investors probably think Allison Transmission Holdings looks like a reliable dividend stock. A low yield is generally a turn-off, but if the prospects for earnings growth were strong, investors might be pleasantly surprised by the long-term results. The company also returned around 9.0% of its market capitalisation to shareholders in the form of stock buybacks over the past year. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.
NYSE:ALSN Historical Dividend Yield, September 29th 2019
Payout ratios
Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. In the last year, Allison Transmission Holdings paid out 11% of its profit as dividends. We'd say its dividends are thoroughly covered by earnings.
Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Allison Transmission Holdings's cash payout ratio last year was 9.7%, which is quite low and suggests that the dividend was thoroughly covered by cash flow. It's encouraging to see that the dividend is covered by both profit and cash flow. This generally suggests the dividend is sustainable, as long as earnings don't drop precipitously.
Is Allison Transmission Holdings's Balance Sheet Risky?
As Allison Transmission Holdings has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. With net debt of 2.12 times its EBITDA, Allison Transmission Holdings has a noticeable amount of debt, although if business stays steady, this may not be overly concerning.
Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Allison Transmission Holdings has EBIT of 7.48 times its interest expense, which we think is adequate.
One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. Allison Transmission Holdings has been paying a dividend for the past seven years. Its dividend has not fluctuated much that time, which we like, but we're conscious that the company might not yet have a track record of maintaining dividends in all economic conditions. During the past seven-year period, the first annual payment was US$0.24 in 2012, compared to US$0.60 last year. Dividends per share have grown at approximately 14% per year over this time.
The dividend has been growing pretty quickly, which could be enough to get us interested even though the dividend history is relatively short. Further research may be warranted.
Dividend Growth Potential
While dividend payments have been relatively reliable, it would also be nice if earnings per share (EPS) were growing, as this is essential to maintaining the dividend's purchasing power over the long term. It's good to see Allison Transmission Holdings has been growing its earnings per share at 44% a year over the past five years. Earnings per share have grown rapidly, and the company is retaining a majority of its earnings. We think this is ideal from an investment perspective, if the company is able to reinvest these earnings effectively.
Conclusion
Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. Firstly, we like that Allison Transmission Holdings has low and conservative payout ratios. Next, earnings growth has been good, but unfortunately the company has not been paying dividends as long as we'd like. All things considered, Allison Transmission Holdings looks like a strong prospect. At the right valuation, it could be something special.
Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 15 analysts we track are forecasting for Allison Transmission Holdings for free with public analyst estimates for the company.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
