Does It Make Sense To Buy Freehold Royalties Ltd. (TSE:FRU) For Its Yield?

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Dividend paying stocks like Freehold Royalties Ltd. (TSE:FRU) 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. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

With Freehold Royalties yielding 7.4% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. It would not be a surprise to discover that many investors buy it for the dividends. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

Explore this interactive chart for our latest analysis on Freehold Royalties!

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. In the last year, Freehold Royalties paid out 2946% of its profit as dividends. A payout ratio above 100% is definitely an item of concern, unless there are some other circumstances that would justify it.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Freehold Royalties paid out 90% of its cash flow last year. This may be sustainable but it does not leave much of a buffer for unexpected circumstances. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Freehold Royalties fortunately did generate enough cash to fund its dividend. Still, if the company repeatedly paid a dividend greater than its profits, we'd be concerned. Very few companies are able to sustainably pay dividends larger than their reported earnings.

Is Freehold Royalties's Balance Sheet Risky?

As Freehold Royalties's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments on debt. Essentially we check that a) a company does not have too much debt, and b) that it can afford to pay the interest. With net debt of 0.73 times its earnings before interest, tax, depreciation and amortisation (EBITDA), Freehold Royalties has an acceptable level of debt.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Freehold Royalties has EBIT of 5.60 times its interest expense, which we think is adequate.

Remember, you can always get a snapshot of Freehold Royalties's latest financial position, by checking our visualisation of its financial health.

Dividend Volatility

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. For the purpose of this article, we only scrutinise the last decade of Freehold Royalties's dividend payments. While its dividends have not been hugely volatile, its most recent dividend is still meaningfully below where it was ten years ago. During the past ten-year period, the first annual payment was CA$1.20 in 2009, compared to CA$0.63 last year. The dividend has shrunk at around 6.2% a year during that period.

We struggle to make a case for buying Freehold Royalties for its dividend, given that payments have shrunk over the past ten years.

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. In the last five years, Freehold Royalties's earnings per share have shrunk at approximately 52% per annum. Declining earnings per share over a number of years is not a great sign for the dividend investor. Without some improvement, this does not bode well for the long term value of a company's dividend.

Conclusion

To summarise, shareholders should always check that Freehold Royalties's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. We're not keen on the fact that Freehold Royalties paid out such a high percentage of its income, although its cashflow is in better shape. Moreover, earnings have been shrinking. While the dividends have been fairly steady, we'd wonder for how much longer this will be sustainable if earnings continue to decline. With this information in mind, we think Freehold Royalties may not be an ideal dividend stock.

Without at least some growth in earnings per share over time, the dividend will eventually come under pressure either from costs or inflation. Very few businesses see earnings consistently shrink year after year in perpetuity though, and so it might be worth seeing what the 4 analysts we track are forecasting for the future.

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 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.