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Costa Group Holdings Limited (ASX:CGC) Investors Should Think About This Before Buying It For Its Dividend

Simply Wall St

Is Costa Group Holdings Limited (ASX:CGC) a good dividend stock? How can we tell? Dividend paying companies with growing earnings can be highly rewarding in the long term. Unfortunately, it's common for investors to be enticed in by the seemingly attractive yield, and lose money when the company has to cut its dividend payments.

With a 2.4% yield and a four-year payment history, investors probably think Costa Group Holdings looks like a reliable dividend stock. A 2.4% yield is not inspiring, but the longer payment history has some appeal. There are a few simple ways to reduce the risks of buying Costa Group Holdings for its dividend, and we'll go through these below.

Explore this interactive chart for our latest analysis on Costa Group Holdings!

ASX:CGC Historical Dividend Yield, September 7th 2019

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, 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. Costa Group Holdings paid out 177% of its profit as dividends, over the trailing twelve month period. Unless there are extenuating circumstances, from the perspective of an investor who hopes to own the company for many years, a payout ratio of above 100% is definitely a concern.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Last year, Costa Group Holdings paid a dividend while reporting negative free cash flow. While there may be an explanation, we think this behaviour is generally not sustainable.

Is Costa Group Holdings's Balance Sheet Risky?

As Costa Group Holdings's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. 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 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 4.45 times its EBITDA, investors are starting to take on a meaningful amount of risk, should the business enter a downturn.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Interest cover of 1.03 times its interest expense is starting to become a concern for Costa Group Holdings, and be aware that lenders may place additional restrictions on the company as well.

Consider getting our latest analysis on Costa Group Holdings'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. Costa Group Holdings has been paying a dividend for the past four years. It has only been paying dividends for a few short years, and the dividend has already been cut at least once. This is one income stream we're not ready to live on. During the past four-year period, the first annual payment was AU$0.06 in 2015, compared to AU$0.085 last year. Dividends per share have grown at approximately 9.1% per year over this time. The growth in dividends has not been linear, but the CAGR is a decent approximation of the rate of change over this time frame.

A reasonable rate of dividend growth is good to see, but we're wary that the dividend history is not as solid as we'd like, having been cut at least once.

Dividend Growth Potential

Given that the dividend has been cut in the past, we need to check if earnings are growing and if that might lead to stronger dividends in the future. Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it's great to see Costa Group Holdings has grown its earnings per share at 41% per annum over the past five years. The company has been growing its EPS at a very rapid rate, while paying out virtually all of its income as dividends. Generally, a company that is growing rapidly while paying out a majority of its earnings, is seeing its debt burden increase. We'd be conscious of any extra risk added by this practice.

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. It's a concern to see that the company paid out such a high percentage of its earnings and cashflow as dividends. Unfortunately, the company has not been able to generate earnings per share growth, and cut its dividend at least once in the past. With this information in mind, we think Costa Group Holdings may not be an ideal dividend stock.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 8 analysts we track are forecasting for Costa Group Holdings 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.