Do Investors Have Good Reason To Be Wary Of Tesco PLC's (LON:TSCO) 2.6% Dividend Yield?

Today we'll take a closer look at Tesco PLC (LON:TSCO) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

A slim 2.6% yield is hard to get excited about, but the long payment history is respectable. At the right price, or with strong growth opportunities, Tesco could have potential. The company also returned around 0.8% of its market capitalisation to shareholders in the form of stock buybacks over the past year. Some simple research can reduce the risk of buying Tesco for its dividend - read on to learn more.

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Payout ratios

Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. Looking at the data, we can see that 92% of Tesco's profits were paid out as dividends in the last 12 months. This is quite a high payout ratio that suggests the dividend is not well covered by earnings.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Unfortunately, while Tesco pays a dividend, it also reported negative free cash flow last year. While there may be a good reason for this, it's not ideal from a dividend perspective.

Remember, you can always get a snapshot of Tesco'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. Tesco has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. This dividend has been unstable, which we define as having been cut one or more times over this time. During the past 10-year period, the first annual payment was UK£0.1 in 2010, compared to UK£0.06 last year. This works out to be a decline of approximately 8.8% per year over that time. Tesco's dividend hasn't shrunk linearly at 8.8% per annum, but the CAGR is a useful estimate of the historical rate of change.

When a company's per-share dividend falls we question if this reflects poorly on either external business conditions, or the company's capital allocation decisions. Either way, we find it hard to get excited about a company with a declining dividend.

Dividend Growth Potential

Given that dividend payments have been shrinking like a glacier in a warming world, we need to check if there are some bright spots on the horizon. Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it's great to see Tesco has grown its earnings per share at 64% per annum over the past five years. Earnings per share have been growing very rapidly, although the company is also paying out virtually all of its profit in dividends. Generally, a company that is growing rapidly while paying out a majority of its earnings, is seeing its debt burden increase. We'd be conscious of any extra risk added by this practice.

Conclusion

To summarise, shareholders should always check that Tesco's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. It's a concern to see that the company paid out such a high percentage of its earnings and cashflow as dividends. Next, earnings growth has been good, but unfortunately the dividend has been cut at least once in the past. In summary, Tesco has a number of shortcomings that we'd find it hard to get past. Things could change, but we think there are likely more attractive alternatives out there.

Investors generally tend to favour companies with a consistent, stable dividend policy as opposed to those operating an irregular one. Meanwhile, despite the importance of dividend payments, they are not the only factors our readers should know when assessing a company. Just as an example, we've come accross 4 warning signs for Tesco you should be aware of, and 2 of them are a bit concerning.

Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 3%.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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