Three Things You Should Check Before Buying CLS Holdings plc (LON:CLI) For Its Dividend

Could CLS Holdings plc (LON:CLI) 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.

In this case, CLS Holdings pays a decent-sized 3.1% dividend yield, and has been distributing cash to shareholders for the past two years. It's certainly an attractive yield, but readers are likely curious about its staying power. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

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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. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. Looking at the data, we can see that 20% of CLS Holdings's profits were paid out as dividends in the last 12 months. We like this low payout ratio, because it implies the dividend is well covered and leaves ample opportunity for reinvestment.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. CLS Holdings paid out 55% of its cash flow as dividends last year, which is within a reasonable range for the average corporation. It's positive to see that CLS Holdings'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.

Is CLS Holdings's Balance Sheet Risky?

As CLS Holdings 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 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. CLS Holdings has net debt of 9.59 times its earnings before interest, tax, depreciation and amortisation (EBITDA) which implies meaningful risk if interest rates rise of earnings decline.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. With EBIT of 4.29 times its interest expense, CLS Holdings's interest cover is starting to look a bit thin. High debt and weak interest cover are not a great combo, and we would be cautious of relying on this company's dividend while these metrics persist.

Consider getting our latest analysis on CLS Holdings's financial position here.

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. The dividend has not fluctuated much, but with a relatively short payment history, we can't be sure this is sustainable across a full market cycle. During the past two-year period, the first annual payment was UK£0.058 in 2017, compared to UK£0.069 last year. This works out to be a compound annual growth rate (CAGR) of approximately 9.5% a year over that time.

The dividend has been growing at a reasonable rate, which we like. We're conscious though that one of the best ways to detect a multi-decade consistent dividend payer, is to watch a company pay dividends for 20 years - a distinction CLS Holdings has not achieved yet.

Dividend Growth Potential

Examining whether the dividend is affordable and stable is important. However, it's also important to assess if earnings per share (EPS) are growing. Over the long term, dividends need to grow at or above the rate of inflation, in order to maintain the recipient's purchasing power. It's good to see CLS Holdings has been growing its earnings per share at 18% a year over the past 5 years. Rapid earnings growth and a low payout ratio suggests this company has been effectively reinvesting in its business. Should that continue, this company could have a bright future.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. Firstly, we like that CLS Holdings pays out a low fraction of earnings. It pays out a higher percentage of its cashflow, although this is within acceptable bounds. We were also glad to see it growing earnings, although its dividend history is not as long as we'd like. Overall we think CLS Holdings is an interesting dividend stock, although it could be better.

You can also discover whether shareholders are aligned with insider interests by checking our visualisation of insider shareholdings and trades in CLS Holdings stock.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding 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.