Here's How We Evaluate AvalonBay Communities, Inc.'s (NYSE:AVB) Dividend

Is AvalonBay Communities, Inc. (NYSE:AVB) 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 popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

A 3.0% yield is nothing to get excited about, but investors probably think the long payment history suggests AvalonBay Communities has some staying power. Before you buy any stock for its dividend however, you should always remember Warren Buffett's two rules: 1) Don't lose money, and 2) Remember rule #1. We'll run through some checks below to help with this.

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Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, 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. In the last year, AvalonBay Communities paid out 66% of its profit as dividends. 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.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. AvalonBay Communities paid out 63% of its free cash flow last year, which is acceptable, but is starting to limit the amount of earnings that can be reinvested into the business. It's positive to see that AvalonBay Communities's dividend is covered by both profits and cash flow, since this is generally a sign that the dividend is sustainable, and a lower payout ratio usually suggests a greater margin of safety before the dividend gets cut.

REITs like AvalonBay Communities often have different rules governing their distributions, so a higher payout ratio on its own is not unusual.

Is AvalonBay Communities's Balance Sheet Risky?

As AvalonBay Communities has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). AvalonBay Communities is carrying net debt of 4.84 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. Interest cover of 4.01 times its interest expense is starting to become a concern for AvalonBay Communities, and be aware that lenders may place additional restrictions on the company as well.

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. For the purpose of this article, we only scrutinise the last decade of AvalonBay Communities's dividend payments. During this period the dividend has been stable, which could imply the business could have relatively consistent earnings power. During the past ten-year period, the first annual payment was US$3.57 in 2009, compared to US$6.08 last year. Dividends per share have grown at approximately 5.5% per year over this time.

Companies like this, growing their dividend at a decent rate, can be very valuable over the long term, if the rate of growth can be maintained.

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. Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it's great to see AvalonBay Communities has grown its earnings per share at 71% per annum over the past five 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 AvalonBay Communities's growth will be slower in the future.

Conclusion

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. First, we think AvalonBay Communities is paying out an acceptable percentage of its cashflow and profit. Second, it has a limited history of earnings per share growth, but at least the dividends have been relatively stable. AvalonBay Communities has a number of positive attributes, but it falls slightly short of our (admittedly high) standards. Were there evidence of a strong moat or an attractive valuation, it could still be well worth a look.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 15 AvalonBay Communities analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield 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.