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Does It Make Sense To Buy Valeo SA (EPA:FR) For Its Yield?

Simply Wall St

Today we'll take a closer look at Valeo SA (EPA:FR) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. 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.

In this case, Valeo likely looks attractive to dividend investors, given its 5.0% dividend yield and nine-year payment history. We'd agree the yield does look enticing. 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

ENXTPA:FR Historical Dividend Yield, September 4th 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. Looking at the data, we can see that 117% of Valeo's profits were paid out as dividends in the last 12 months. A payout ratio above 100% is definitely an item of concern, unless there are some other circumstances that would justify it.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Valeo paid out 83% of its cash flow last year. This may be sustainable but it does not leave much of a buffer for unexpected circumstances. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Valeo fortunately did generate enough cash to fund its dividend. If executives were to continue paying more in dividends than the company reported in profits, we'd view this as a warning sign. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.

Is Valeo's Balance Sheet Risky?

As Valeo'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. Valeo has net debt of 1.54 times its EBITDA, which we think is not too troublesome.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Valeo has interest cover of more than 12 times its interest expense, which we think is quite strong.

Consider getting our latest analysis on Valeo'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 first recorded dividend for Valeo, in the last decade, was nine years ago. The dividend has been quite stable over the past nine 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 nine-year period, the first annual payment was €0.40 in 2010, compared to €1.25 last year. This works out to be a compound annual growth rate (CAGR) of approximately 13% a year over that 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

Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. Over the past five years, it looks as though Valeo's EPS have declined at around 11% a year. With this kind of significant decline, we always wonder what has changed in the business. Dividends are about stability, and Valeo's earnings per share, which support the dividend, have been anything but stable.

Conclusion

To summarise, shareholders should always check that Valeo'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 Valeo paid out such a high percentage of its income, although its cashflow is in better shape. Second, the company has not been able to generate earnings growth, and its history of dividend payments too short for us to thoroughly evaluate the dividend's consistency across an economic cycle. There are a few too many issues for us to get comfortable with Valeo from a dividend perspective. Businesses can change, but we would struggle to identify why an investor should rely on this stock for their income.

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.