Could Grainger plc (LON:GRI) 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 1.9% yield is hard to get excited about, but the long payment history is respectable. At the right price, or with strong growth opportunities, Grainger could have potential. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.
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. Grainger paid out 26% of its profit as dividends, over the trailing twelve month period. This is a middling range that strikes a nice balance between paying dividends to shareholders, and retaining enough earnings to invest in future growth. Plus, there is room to increase the payout ratio over time.
We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. Grainger paid out 14% of its free cash flow as dividends last year, which is conservative and suggests the dividend is sustainable. It's positive to see that Grainger'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 Grainger's Balance Sheet Risky?
As Grainger has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with 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. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. Grainger has net debt of 10.44 times its EBITDA, which we think carries substantial risk if earnings aren't sustainable.
Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 4.27 times its interest expense, Grainger'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.
Remember, you can always get a snapshot of Grainger's latest financial position, by checking our visualisation of its financial health.
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. Grainger has been paying dividends for a long time, but for the purpose of this analysis, we only examine the past 10 years of payments. Its dividend payments have declined on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was UK£0.039 in 2010, compared to UK£0.052 last year. This works out to be a compound annual growth rate (CAGR) of approximately 2.9% a year over that time. The growth in dividends has not been linear, but the CAGR is a decent approximation of the rate of change over this time frame.
We're glad to see the dividend has risen, but with a limited rate of growth and fluctuations in the payments, we don't think this is an attractive combination.
Dividend Growth Potential
With a relatively unstable dividend, it's even more important to see if earnings per share (EPS) are growing. Why take the risk of a dividend getting cut, unless there's a good chance of bigger dividends in future? Grainger's earnings per share have been essentially flat over the past five years. Over the long term, steady earnings per share is a risk as the value of the dividends can be reduced by inflation. Grainger is paying out less than half of its earnings, which we like. However, earnings per share are unfortunately not growing much. Might this suggest that the company should pay a higher dividend instead?
We'd also point out that Grainger issued a meaningful number of new shares in the past year. Regularly issuing new shares can be detrimental - it's hard to grow dividends per share when new shares are regularly being created.
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. First, we like that the company's dividend payments appear well covered, although the retained capital also needs to be effectively reinvested. Second, earnings have been essentially flat, and its history of dividend payments is chequered - having cut its dividend at least once in the past. Grainger 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.
Market movements attest to how highly valued a consistent dividend policy is compared to one which is more unpredictable. However, there are other things to consider for investors when analysing stock performance. Just as an example, we've come accross 3 warning signs for Grainger you should be aware of, and 1 of them is significant.
If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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