Dividend paying stocks like China Flavors and Fragrances Company Limited (HKG:3318) 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 only a three-year payment history, and a 2.0% yield, investors probably think China Flavors and Fragrances is not much of a dividend stock. A low dividend might not be a bad thing, if the company is reinvesting heavily and growing its sales and profits. There are a few simple ways to reduce the risks of buying China Flavors and Fragrances for its dividend, and we'll go through these below.
SEHK:3318 Historical Dividend Yield, August 27th 2019
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. 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. In the last year, China Flavors and Fragrances paid out 21% of its profit as dividends. Given the low payout ratio, it is hard to envision the dividend coming under threat, barring a catastrophe.
We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Last year, China Flavors and Fragrances paid a dividend while reporting negative free cash flow. While there may be an explanation, we think this behaviour is generally not sustainable.
Is China Flavors and Fragrances's Balance Sheet Risky?
As China Flavors and Fragrances 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 3.42 times its EBITDA, investors are starting to take on a meaningful amount of risk, should the business enter a downturn.
We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Interest cover of 2.75 times its interest expense is starting to become a concern for China Flavors and Fragrances, and be aware that lenders may place additional restrictions on the company as well.
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 three-year period, the first annual payment was CN¥0.025 in 2016, compared to CN¥0.029 last year. Dividends per share have grown at approximately 5.1% per year over this 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 China Flavors and Fragrances has not achieved yet.
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. China Flavors and Fragrances's EPS are effectively flat over the past five years. Flat earnings per share are acceptable for a time, but over the long term, the purchasing power of the company's dividends could be eroded by inflation. As we saw above, earnings per share growth has not been strong. However, the payout ratio is low, and some companies can deliver adequate dividend performance simply by increasing the payout ratio.
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, the company has a conservative payout ratio, although we'd note that its cashflow in the past year was substantially lower than its reported profit. Unfortunately, there hasn't been any earnings growth, and the company's dividend history has been too short for us to evaluate the consistency of the dividend. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than China Flavors and Fragrances out there.
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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.
