Dividend paying stocks like Ambuja Cements Limited (NSE:AMBUJACEM) 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 popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

A slim 0.7% yield is hard to get excited about, but the long payment history is respectable. At the right price, or with strong growth opportunities, Ambuja Cements could have potential. There are a few simple ways to reduce the risks of buying Ambuja Cements for its dividend, and we'll go through these below.

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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, Ambuja Cements paid out 12% of its profit as dividends. Given the low payout ratio, it is hard to envision the dividend coming under threat, barring a catastrophe.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Ambuja Cements's cash payout ratio in the last year was 30%, which suggests dividends were well covered by cash generated by the business. 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.

With a strong net cash balance, Ambuja Cements investors may not have much to worry about in the near term from a dividend perspective.

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

Dividend Volatility

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. Ambuja Cements has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. The dividend has been cut by more than 20% on at least one occasion historically. During the past ten-year period, the first annual payment was ₹2.20 in 2009, compared to ₹1.50 last year. This works out to be a decline of approximately 3.8% per year over that time. Ambuja Cements's dividend hasn't shrunk linearly at 3.8% per annum, but the CAGR is a useful estimate of the historical rate of change.

When a company's per-share dividend falls we question if this reflects poorly on either external business conditions, or the company's capital allocation decisions. Either way, we find it hard to get excited about a company with a declining dividend.

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? Earnings have grown at around 8.5% a year for the past five years, which is better than seeing them shrink! A low payout ratio and strong historical earnings growth suggests Ambuja Cements has been effectively reinvesting in its business. We think this generally bodes well for its dividend prospects.

Conclusion

To summarise, shareholders should always check that Ambuja Cements's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. It's great to see that Ambuja Cements is paying out a low percentage of its earnings and cash flow. We were also glad to see it growing earnings, but it was concerning to see the dividend has been cut at least once in the past. All things considered, Ambuja Cements looks like a strong prospect. At the right valuation, it could be something special.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 14 Ambuja Cements analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 3%.

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.

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.