U.S. Markets open in 7 hrs 13 mins

What To Know Before Buying A. O. Smith Corporation (NYSE:AOS) For Its Dividend

Simply Wall St

Is A. O. Smith Corporation (NYSE:AOS) a good dividend stock? How can we tell? Dividend paying companies with growing earnings can be highly rewarding in the long term. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

While A. O. Smith's 1.9% dividend yield is not the highest, we think its lengthy payment history is quite interesting. The company also bought back stock during the year, equivalent to approximately 3.5% 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 A. O. Smith!

NYSE:AOS Historical Dividend Yield, September 2nd 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 34% of A. O. Smith's profits were paid out as dividends in the last 12 months. This is a middling range that strikes a nice balance between paying dividends to shareholders, and retaining enough earnings to invest in future growth. Plus, there is room to increase the payout ratio over time.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. A. O. Smith's cash payout ratio in the last year was 42%, which suggests dividends were well covered by cash generated by the business. It's encouraging to see that the dividend is covered by both profit and cash flow. This generally suggests the dividend is sustainable, as long as earnings don't drop precipitously.

Consider getting our latest analysis on A. O. Smith'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. A. O. Smith 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 US$0.13 in 2009, compared to US$0.88 last year. Dividends per share have grown at approximately 21% per year over this time. A. O. Smith's dividend payments have fluctuated, so it hasn't grown 21% every year, but the CAGR is a useful rule of thumb for approximating the historical growth.

It's not great to see that the payment has been cut in the past. We're generally more wary of companies that have cut their dividend before, as they tend to perform worse in an economic downturn.

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. It's good to see A. O. Smith has been growing its earnings per share at 22% a year over the past 5 years. Earnings per share have rocketed in recent times, and we like that the company is retaining more than half of its earnings to reinvest. However, always remember that very few companies can grow at double digit rates forever.

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 like that the company's dividend payments appear well covered, although the retained capital also needs to be effectively reinvested. Second, earnings per share have been essentially flat, and its history of dividend payments is chequered - having cut its dividend at least once in the past. All things considered, A. O. Smith looks like a strong prospect. At the right valuation, it could be something special.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 10 analysts we track are forecasting for A. O. Smith 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.