Three Things You Should Check Before Buying First Derivatives plc (LON:FDP) For Its Dividend

Could First Derivatives plc (LON:FDP) be an attractive dividend share to own for the long haul? Investors are often drawn to strong companies with the idea of reinvesting the dividends. 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 slim 1.2% yield is hard to get excited about, but the long payment history is respectable. At the right price, or with strong growth opportunities, First Derivatives could have potential. Remember though, given the recent drop in its share price, First Derivatives's yield will look higher, even though the market may now be expecting a decline in its long-term prospects. When buying stocks for their dividends, you should always run through the checks below, to see if the dividend looks sustainable.

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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, First Derivatives paid out 53% of its profit as dividends. This is a healthy payout ratio, and while it does limit the amount of earnings that can be reinvested in the business, there is also some room to lift 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. First Derivatives paid out 60% 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 First Derivatives'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.

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 First Derivatives'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£0.082 in 2009, compared to UK£0.27 last year. Dividends per share have grown at approximately 13% per year over this time.

Dividends have been growing pretty quickly, and even more impressively, they haven't experienced any notable falls during this period.

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. Earnings have grown at around 8.1% a year for the past five years, which is better than seeing them shrink! The rate at which earnings have grown is quite decent, and by paying out more than half of its earnings as dividends, the company is striking a reasonable balance between reinvestment and returns to shareholders.

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 Derivatives's is paying out more than half its income as dividends, but at least the dividend is covered by both reported earnings and cashflow. That said, we were glad to see it growing earnings and paying a fairly consistent dividend. First Derivatives 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.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 5 analysts we track are forecasting for First Derivatives for free with public 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.