Dividend paying stocks like China Petroleum & Chemical Corporation (HKG:386) 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. Unfortunately, it's common for investors to be enticed in by the seemingly attractive yield, and lose money when the company has to cut its dividend payments.
A high yield and a long history of paying dividends is an appealing combination for China Petroleum & Chemical. We'd guess that plenty of investors have purchased it for the income. Before you buy any stock for its dividend however, you should always remember Warren Buffett's two rules: 1) Don't lose money, and 2) Remember rule #1. We'll run through some checks below to help with this.
SEHK:386 Historical Dividend Yield, January 27th 2020
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. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. China Petroleum & Chemical paid out 101% of its profit as dividends, over the trailing twelve month period. With a payout ratio this high, we'd say its dividend is not well covered by earnings. This may be fine if earnings are growing, but it might not take much of a downturn for the dividend to come under pressure.
We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Unfortunately, while China Petroleum & Chemical pays a dividend, it also reported negative free cash flow last year. While there may be a good reason for this, it's not ideal from a dividend perspective.
Is China Petroleum & Chemical's Balance Sheet Risky?
As China Petroleum & Chemical's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. 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 measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). China Petroleum & Chemical has net debt of 0.079 times its EBITDA, which we think is not too troublesome.
Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. China Petroleum & Chemical has EBIT of 11.21 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. China Petroleum & Chemical has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. This dividend has been unstable, which we define as having been cut one or more times over this time. During the past ten-year period, the first annual payment was CN¥0.092 in 2010, compared to CN¥0.38 last year. This works out to be a compound annual growth rate (CAGR) of approximately 15% a year over that time. The dividends haven't grown at precisely 15% every year, but this is a useful way to average out the historical rate of growth.
China Petroleum & Chemical has grown distributions at a rapid rate despite cutting the dividend at least once in the past. Companies that cut once often cut again, but it might be worth considering if the business has turned a corner.
Dividend Growth Potential
With a relatively unstable dividend, it's even more important to see if earnings per share (EPS) are growing. Why take the risk of a dividend getting cut, unless there's a good chance of bigger dividends in future? Over the past five years, it looks as though China Petroleum & Chemical's EPS have declined at around 7.9% a year. A modest decline in earnings per share is not great to see, but it doesn't automatically make a dividend unsustainable. Still, we'd vastly prefer to see EPS growth when researching dividend stocks.
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. We're a bit uncomfortable with China Petroleum & Chemical paying out a high percentage of both its cashflow and earnings. Earnings per share have been falling, and the company has cut its dividend at least once in the past. From a dividend perspective, this is a cause for concern. There are a few too many issues for us to get comfortable with China Petroleum & Chemical from a dividend perspective. Businesses can change, but we would struggle to identify why an investor should rely on this stock for their income.
Given that earnings are not growing, the dividend does not look nearly so attractive. Businesses can change though, and we think it would make sense to see what analysts are forecasting for the company.
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.
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