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Dividend paying stocks like Red Eléctrica Corporación, S.A. (BME:REE) 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 a nine-year payment history and a 5.1% yield, many investors probably find Red Eléctrica Corporación intriguing. We'd agree the yield does look enticing. Some simple research can reduce the risk of buying Red Eléctrica Corporación for its dividend - read on to learn more.
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 be 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 75% of Red Eléctrica Corporación's profits were paid out as dividends in the last 12 months. Paying out a majority of its earnings limits the amount that can be reinvested in the business. This may indicate a commitment to paying a dividend, or a dearth of investment opportunities.
Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Red Eléctrica Corporación paid out 68% of its cash flow as dividends last year, which is within a reasonable range for the average corporation. 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.
Is Red Eléctrica Corporación's Balance Sheet Risky?
As Red Eléctrica Corporación 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). Red Eléctrica Corporación is carrying net debt of 3.33 times its EBITDA, which is getting towards the upper limit of our comfort range on a dividend stock that the investor hopes will endure a wide range of economic circumstances.
We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Red Eléctrica Corporación has EBIT of 8.03 times its interest expense, which we think is adequate.
Remember, you can always get a snapshot of Red Eléctrica Corporación's latest financial position, by checking our visualisation of its financial health.
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 last decade of data, we can see that Red Eléctrica Corporación paid its first dividend at least 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 €0.37 in 2010, compared to €0.98 last year. This works out to be a compound annual growth rate (CAGR) of approximately 11% a year over that time.
Red Eléctrica Corporación 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. Over the long term, dividends need to grow at or above the rate of inflation, in order to maintain the recipient's purchasing power. Earnings have grown at around 5.9% a year for the past five years, which is better than seeing them shrink! Past earnings growth has been decent, but unless this is one of those rare businesses that can grow without additional capital investment or marketing spend, we'd generally expect the higher payout ratio to limit its future growth prospects.
Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. Red Eléctrica Corporación's is paying out more than half its income as dividends, but at least the dividend is covered by both reported earnings and cashflow. Unfortunately, earnings growth has also been mediocre, and we think it has not been paying dividends long enough to demonstrate resilience across economic cycles. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than Red Eléctrica Corporación out there.
Earnings growth generally bodes well for the future value of company dividend payments. See if the 13 Red Eléctrica Corporación analysts we track are forecasting continued growth with our free report on analyst estimates 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 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. Thank you for reading.