Dividend paying stocks like The Colonial Motor Company Limited (NZSE:CMO) 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. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

With Colonial Motor yielding 7.5% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. It would not be a surprise to discover that many investors buy it for the dividends. Remember though, given the recent drop in its share price, Colonial Motor's yield will look higher, even though the market may now be expecting a decline in its long-term prospects. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.

Explore this interactive chart for our latest analysis on Colonial Motor!

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. In the last year, Colonial Motor paid out 77% of its profit as dividends. Paying out a majority of its earnings limits the amount that can be reinvested in the business. This may indicate a commitment to paying a dividend, or a dearth of investment opportunities.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Colonial Motor paid out 99% of its free cash flow last year, which we think is concerning if cash flows do not improve. While Colonial Motor's dividends were covered by the company's reported profits, free cash flow is somewhat more important, so it's not great to see that the company didn't generate enough cash to pay its dividend. Cash is king, as they say, and were Colonial Motor to repeatedly pay dividends that aren't well covered by cashflow, we would consider this a warning sign.

Is Colonial Motor's Balance Sheet Risky?

As Colonial Motor has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A rough way to check this is with these two simple ratios: a) net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and b) 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 2.46 times its EBITDA, Colonial Motor's debt burden is within a normal range for most listed companies.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Net interest cover of 7.73 times its interest expense appears reasonable for Colonial Motor, although we're conscious that even high interest cover doesn't make a company bulletproof.

Remember, you can always get a snapshot of Colonial Motor's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. For the purpose of this article, we only scrutinise the last decade of Colonial Motor's dividend payments. During this period the dividend has been stable, which could imply the business could have relatively consistent earnings power. During the past ten-year period, the first annual payment was NZ$0.13 in 2010, compared to NZ$0.45 last year. This works out to be a compound annual growth rate (CAGR) of approximately 13% a year over that time.

With rapid dividend growth and no notable cuts to the dividend over a lengthy period of time, we think this company has a lot going for it.

Dividend Growth Potential

Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. While there may be fluctuations in the past , Colonial Motor's earnings per share have basically not grown from where they were five years ago. Over the long term, steady earnings per share is a risk as the value of the dividends can be reduced by inflation. Colonial Motor's earnings per share have barely grown, which is not ideal - perhaps this is why the company pays out the majority of its earnings to shareholders. When the rate of return on reinvestment opportunities falls below a certain minimum level, companies often elect to pay a larger dividend instead. This is why many mature companies often have larger dividend yields.

Conclusion

To summarise, shareholders should always check that Colonial Motor's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, we think Colonial Motor has an acceptable payout ratio, although its dividend was not well covered by cashflow. Earnings per share have not been growing, but we respect a company that maintains a relatively stable dividend. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than Colonial Motor out there.

Investors generally tend to favour companies with a consistent, stable dividend policy as opposed to those operating an irregular one. Meanwhile, despite the importance of dividend payments, they are not the only factors our readers should know when assessing a company. For instance, we've picked out 2 warning signs for Colonial Motor that investors should take into consideration.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.