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Should You Buy EDAG Engineering Group AG (FRA:ED4) For Its Dividend?

Simply Wall St

Could EDAG Engineering Group AG (FRA:ED4) be an attractive dividend share to own for the long haul? Investors are often drawn to strong companies with the idea of reinvesting the 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.

In this case, EDAG Engineering Group pays a decent-sized 5.8% dividend yield, and has been distributing cash to shareholders for the past three years. A high yield probably looks enticing, but investors are likely wondering about the short payment history. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.

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DB:ED4 Historical Dividend Yield, May 21st 2019

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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. So we need to be form a view on if a company's dividend is sustainable, relative to its net profit after tax. Looking at the data, we can see that 77% of EDAG Engineering Group's profits were paid out as dividends in the last 12 months. 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. EDAG Engineering Group paid out 55% of its cash flow as dividends last year, which is within a reasonable range for the average corporation. It's positive to see that EDAG Engineering Group'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 EDAG Engineering Group's Balance Sheet Risky?

As EDAG Engineering 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 on debt. Essentially we check that a) a company does not have too much debt, and b) that it can afford to pay the interest. With net debt of above 3x EBITDA, investors are starting to take on a meaningful amount of risk, should the business enter a downturn.

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 7.87 times its interest expense appears reasonable for EDAG Engineering Group, although we're conscious that even high interest cover doesn't make a company bulletproof.

Consider getting our latest analysis on EDAG Engineering Group's financial position here.

Dividend Volatility

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. The company has been paying a stable dividend for a few years now, but we'd like to see more evidence of consistency over a longer period. Its most recent annual dividend was €0.75 per share, effectively flat on its first payment three years ago.

It's good to see at least some dividend growth. Yet with a relatively short dividend paying history, we wouldn't want to depend on this dividend too heavily.

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. Over the past five years, it looks as though EDAG Engineering Group's EPS have declined at around 70% a year. Declining earnings per share over a number of years is not a great sign for the dividend investor. Without some improvement, this does not bode well for the long term value of a company's dividend.

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. First, we think EDAG Engineering Group is paying out an acceptable percentage of its cashflow and profit. Earnings per share have been falling, and the company has a relatively short dividend history - shorter than we like, anyway. In summary, EDAG Engineering Group has a number of shortcomings that we'd find it hard to get past. Things could change, but we think there are likely more attractive alternatives out there.

Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. Businesses can change though, and we think it would make sense to see what analysts are forecasting for the company.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 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.