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Should KAR Auction Services, Inc. (NYSE:KAR) Be Part Of Your Dividend Portfolio?

Simply Wall St

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Today we'll take a closer look at KAR Auction Services, Inc. (NYSE:KAR) 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. 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.

Investors might not know much about KAR Auction Services's dividend prospects, even though it has been paying dividends for the last six years and offers a 2.5% yield. While the yield may not look too great, the relatively long payment history is interesting. The company also bought back stock during the year, equivalent to approximately 2.0% of the company's market capitalisation at the time. 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

NYSE:KAR Historical Dividend Yield, May 13th 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. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. KAR Auction Services paid out 59% of its profit as dividends, over the trailing twelve month period. A payout ratio above 50% generally implies a business is reaching maturity, although it is still possible to reinvest in the business or increase the dividend over time.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. KAR Auction Services's cash payout ratio in the last year was 39%, which suggests dividends were well covered by cash generated by the business.


Is KAR Auction Services's Balance Sheet Risky?

As KAR Auction Services 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 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 more than 5x EBITDA, KAR Auction Services could be described as a highly leveraged company. While some companies can handle this level of leverage, we'd be concerned about the dividend sustainability if there was any risk of an earnings 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. With EBIT of 3.06 times its interest expense, KAR Auction Services's interest cover is starting to look a bit thin. Low interest cover and high debt can create problems right when the investor least needs them. We're generally reluctant to rely on the dividend of companies with these traits.

Remember, you can always get a snapshot of KAR Auction Services's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

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. Looking at the data, we can see that KAR Auction Services has been paying a dividend for the past six years. The company has been paying a stable dividend for a while now, which is great. However we'd prefer to see consistency for a few more years before giving it our full seal of approval. During the past six-year period, the first annual payment was US$0.76 in 2013, compared to US$1.40 last year. Dividends per share have grown at approximately 11% per year over this time.

KAR Auction Services has been growing its dividend quite rapidly, which is exciting. However, the short payment history makes us question whether this performance will persist across a full market cycle.

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 good to see KAR Auction Services has been growing its earnings per share at 37% a year over the past 5 years. Earnings per share are sharply up, but we wonder if paying out more than half its earnings (leaving less for reinvestment) is an implicit signal that KAR Auction Services's growth will be slower in the future.

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 KAR Auction Services has an acceptable payout ratio and its dividend is well covered by cashflow. We were also glad to see it growing earnings, although its dividend history is not as long as we'd like. Overall we think KAR Auction Services is an interesting dividend stock, although it could be better.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 12 KAR Auction Services analysts we track are forecasting continued growth with our free report on 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.