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Should You Buy Collins Foods Limited (ASX:CKF) For Its Dividend?

Simply Wall St

Dividend paying stocks like Collins Foods Limited (ASX:CKF) 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 your dividends, it's important to be more stringent with your investments than the average punter. Regular readers know we like to apply the same approach to each dividend stock, and we hope you'll find our analysis useful.

Investors might not know much about Collins Foods's dividend prospects, even though it has been paying dividends for the last seven years and offers a 2.0% yield. While the yield may not look too great, the relatively long payment history is interesting. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

Click the interactive chart for our full dividend analysis

ASX:CKF Historical Dividend Yield, October 25th 2019

Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, 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, Collins Foods paid out 58% of its profit as dividends. A payout ratio above 50% generally implies a business is reaching maturity, although it is still possible to reinvest in the business or increase the dividend over time.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Of the free cash flow it generated last year, Collins Foods paid out 50% as dividends, suggesting the dividend is affordable. It's positive to see that Collins Foods's dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

Is Collins Foods's Balance Sheet Risky?

As Collins Foods 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 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). With net debt of 2.04 times its EBITDA, Collins Foods has a noticeable amount of debt, although if business stays steady, this may not be overly concerning.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Collins Foods has EBIT of 6.42 times its interest expense, which we think is adequate.

Remember, you can always get a snapshot of Collins Foods'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. Collins Foods has been paying a dividend for the past seven years. The dividend has been quite stable over the past seven years, which is great to see - although we usually like to see the dividend maintained for a decade before giving it full marks, though. During the past seven-year period, the first annual payment was AU$0.065 in 2012, compared to AU$0.21 last year. Dividends per share have grown at approximately 18% per year over this time.

We're not overly excited about the relatively short history of dividend payments, however the dividend is growing at a nice rate and we might take a closer look.

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 Collins Foods has been growing its earnings per share at 17% a year over the past five years. Collins Foods's earnings per share have grown rapidly in recent years, although more than half of its profits are being paid out as dividends, which makes us wonder if the company has a limited number of reinvestment opportunities in its business.

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. Collins Foods's payout ratios are within a normal range for the average corporation, and we like that its cashflow was stronger than reported profits. Next, earnings growth has been good, but unfortunately the company has not been paying dividends as long as we'd like. Overall we think Collins Foods is an interesting dividend stock, although it could be better.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 4 analysts we track are forecasting for Collins Foods for free with public analyst estimates for the company.

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