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Consider This Before Buying Allergan plc (NYSE:AGN) For The 2.2% Dividend

Simply Wall St

Is Allergan plc (NYSE:AGN) a good dividend stock? How would you know? Dividend paying companies with growing earnings can be highly rewarding in the long term. 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.

Some readers mightn't know much about Allergan's 2.2% dividend, as it has only been paying distributions for the last three years. While it may not look like much, if earnings are growing it could become quite interesting. The company also bought back stock during the year, equivalent to approximately 4.7% of the company's market capitalisation at the time. 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 Allergan!

NYSE:AGN Historical Dividend Yield, May 16th 2019

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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 be form a view on if a company's dividend is sustainable, relative to its net profit after tax. While Allergan pays a dividend, it reported a loss over the last year. When a company recently reported a loss, we should investigate if its cash flows covered the dividend.

As a loss-making company, we can also measure Allergan's dividend payments against its levered free cash flow, to see if enough cash was generated to cover the dividend. Allergan paid out 20% of its free cash flow as dividends last year, which is conservative and suggests the dividend is sustainable.


Is Allergan's Balance Sheet Risky?

Given Allergan is paying a dividend but reported a loss over the past year, we need to check its balance sheet for signs of financial distress. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures a company's total debt load relative to its earnings (lower = less debt), while net interest cover measures the company's ability to pay the interest on its debt (higher = greater ability to pay interest costs). 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. Allergan has interest cover of less than 1 - which suggests its earnings are not high enough to cover even the interest payments on its debt. This is potentially quite serious, and we would likely avoid the stock if it were not resolved quickly.

Consider getting our latest analysis on Allergan's financial position here.

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. 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. During the past three-year period, the first annual payment was US$2.80 in 2016, compared to US$2.96 last year. Dividends per share have grown at approximately 1.9% per year over this time.

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. Growing EPS can help maintain or increase the purchasing power of the dividend over the long run. It's not great to see that Allergan's have fallen at approximately 7.4% over the past five years. If earnings continue to decline, the dividend may come under pressure. Every investor should make an assessment of whether the company is taking steps to stabilise the situation.

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. We're a bit uncomfortable with its high payout ratio, although we note cashflow was stronger than income. Earnings per share are down, and to our mind Allergan has not been paying a dividend long enough to demonstrate its resilience across economic cycles. Overall, Allergan falls short in several key areas here. Unless the investor has strong grounds for an alternative conclusion, we find it hard to get interested in a dividend stock with these characteristics.

Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. See if the 20 analysts are forecasting a turnaround in our free collection of analyst estimates here.

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.