Dividend paying stocks like Viva Energy Group Limited (ASX:VEA) 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. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.
Viva Energy Group has only been paying a dividend for a year or so, so investors might be curious about its 2.2% yield. There are a few simple ways to reduce the risks of buying Viva Energy Group for its dividend, and we'll go through these below.
ASX:VEA Historical Dividend Yield, September 9th 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. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. Viva Energy Group paid out 26% of its profit as dividends, over the trailing twelve month period. This is a medium payout level that leaves enough capital in the business to fund opportunities that might arise, while also rewarding shareholders. Besides, if reinvestment opportunities dry up, the company has room to increase the dividend.
We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Viva Energy Group paid out 50% of its cash flow as dividends last year, which is within a reasonable range for the average corporation. 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 Viva Energy Group's Balance Sheet Risky?
As Viva Energy Group 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. Viva Energy Group has net debt of 0.49 times its EBITDA, which is generally an okay level of debt for most companies.
We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. With EBIT of 1.95 times its interest expense, Viva Energy Group's interest cover is starting to look a bit thin.
Before buying a stock for its income, we want to see if the dividends have been stable in the past, and if the company has a track record of maintaining its dividend. With a payment history of less than 2 years, we think it's a bit too soon to think about living on the income from its dividend. Dividend payments have fallen sharply, down 13% over that time.
A shrinking dividend over a one-year period is not ideal, and we'd be concerned about investing in a dividend stock that lacks a solid record of growing dividends per share.
Dividend Growth Potential
Examining whether the dividend is affordable and stable is important. However, it's also important to assess if earnings per share (EPS) are growing. Over the long term, dividends need to grow at or above the rate of inflation, in order to maintain the recipient's purchasing power. Viva Energy Group has grown its earnings per share at 9.8% per annum over the past three years. It's good to see decent earnings growth and a low payout ratio. Companies with these characteristics often display the fastest dividend growth over the long term - assuming earnings can be maintained, of course.
Conclusion
When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. Firstly, we like that Viva Energy Group pays out a low fraction of earnings. It pays out a higher percentage of its cashflow, although this is within acceptable bounds. Second, the company has not been able to generate earnings growth, and its history of dividend payments too short for us to thoroughly evaluate the dividend's consistency across an economic cycle. Ultimately, Viva Energy Group comes up short on our dividend analysis. It's not that we think it is a bad company - just that there are likely more appealing dividend prospects out there on this analysis.
Earnings growth generally bodes well for the future value of company dividend payments. See if the 7 Viva Energy Group analysts we track are forecasting continued growth with our freereport on 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.
