Dividend paying stocks like Babcock International Group PLC (LON:BAB) 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. If you are hoping to live on your dividends, it’s important to be more stringent with your investments than the average punter. Regular readers know we like to apply the same approach to each dividend stock, and we hope you’ll find our analysis useful.
A high yield and a long history of paying dividends is an appealing combination for Babcock International Group. We’d guess that plenty of investors have purchased it for the income. Some simple analysis can reduce the risk of holding Babcock International Group for its dividend, and we’ll focus on the most important aspects below.
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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. Comparing dividend payments to a company’s net profit after tax is a simple way of reality-checking whether a dividend is sustainable. In the last year, Babcock International Group paid out 56% 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. Babcock International Group paid out 178% of its free cash last year. Cash flows can be lumpy, but this dividend was not well covered by cash flow. Paying out more than 100% of your free cash flow in dividends is generally not a long-term, sustainable state of affairs, so we think shareholders should watch this metric closely. Babcock International Group paid out less in dividends than it reported in profits, but unfortunately it didn’t generate enough free cash flow to cover the dividend. Were it to repeatedly pay dividends that were not well covered by cash flow, this could be a risk to Babcock International Group’s ability to maintain its dividend.
Is Babcock International Group’s Balance Sheet Risky?
As Babcock International Group 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 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). With net debt of 2.49 times its EBITDA, Babcock International Group’s debt burden is within a normal range for most listed companies.
We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company’s net interest expense. Babcock International Group has EBIT of 7.61 times its interest expense, which we think is adequate.
Consider getting our latest analysis on Babcock International Group’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. For the purpose of this article, we only scrutinise the last decade of Babcock International Group’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 UK£0.14 in 2010, compared to UK£0.30 last year. This works out to be a compound annual growth rate (CAGR) of approximately 7.6% a year over that time.
Dividends have grown at a reasonable rate over this period, and without any major cuts in the payment over time, we think this is an attractive combination.
Dividend Growth Potential
While dividend payments have been relatively reliable, it would also be nice if earnings per share (EPS) were growing, as this is essential to maintaining the dividend’s purchasing power over the long term. Earnings have grown at around 3.9% a year for the past five years, which is better than seeing them shrink! Growth of 3.9% is relatively anaemic growth, which we wonder about. When a business is not growing, it often makes more sense to pay higher dividends to shareholders rather than retain the cash with no way to utilise it.
Conclusion
To summarise, shareholders should always check that Babcock International Group’s dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, the company has a payout ratio that was within an average range for most dividend stocks, but it paid out virtually all of its generated cash flow. Earnings growth has been limited, but we like that the dividend payments have been fairly consistent. While we’re not hugely bearish on it, overall we think there are potentially better dividend stocks than Babcock International Group out there.
Earnings growth generally bodes well for the future value of company dividend payments. See if the 10 Babcock International Group 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%.
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.
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