Dividend paying stocks like Deutsche Telekom AG (ETR:DTE) 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. 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 Deutsche Telekom yielding 4.8% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. It would not be a surprise to discover that many investors buy it for the dividends. Some simple analysis can reduce the risk of holding Deutsche Telekom for its dividend, and we'll focus on the most important aspects below.
Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. In the last year, Deutsche Telekom paid out 119% of its profit as dividends. 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.
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, Deutsche Telekom paid out 47% as dividends, suggesting the dividend is affordable. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Deutsche Telekom fortunately did generate enough cash to fund its dividend. Still, if the company repeatedly paid a dividend greater than its profits, we'd be concerned. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.
Is Deutsche Telekom's Balance Sheet Risky?
As Deutsche Telekom'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 is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. Deutsche Telekom has net debt of 2.62 times its EBITDA. Using debt can accelerate business growth, but also increases the risks.
Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Interest cover of 4.63 times its interest expense is starting to become a concern for Deutsche Telekom, and be aware that lenders may place additional restrictions on the company as well.
Consider getting our latest analysis on Deutsche Telekom's financial position here.
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. Deutsche Telekom 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 €0.78 in 2010, compared to €0.70 last year. The dividend has shrunk at around 1.1% a year during that period. Deutsche Telekom's dividend has been cut sharply at least once, so it hasn't fallen by 1.1% every year, but this is a decent approximation of the long term change.
A shrinking dividend over a ten-year period is not ideal, and we'd be concerned about investing in a dividend stock that lacks a solid record of growing dividends per share.
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 Deutsche Telekom has grown its earnings per share at 22% per annum over the past five years. Earnings per share have been growing very rapidly, although the company is also paying out virtually all of its profit in dividends. While EPS could grow fast enough to make the dividend sustainable, in this type of situation, we'd want to pay extra attention to any fragilities in the company's balance sheet.
To summarise, shareholders should always check that Deutsche Telekom's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. We're not keen on the fact that Deutsche Telekom paid out such a high percentage of its income, although its cashflow is in better shape. Next, earnings growth has been good, but unfortunately the dividend has been cut at least once in the past. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than Deutsche Telekom out there.
Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 18 analysts we track are forecasting for Deutsche Telekom 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%.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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