Analog Devices' Dividends May Not Last Forever

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Not only do companies that have quarterly or annual payouts provide you with a steady stream of income, they also have the potential for capital appreciation. Simply put, dividend stocks can give your portfolio what almost no other investment can -- both income and growth.

At The Motley Fool, we're avid fans of dividends -- and not just because we like that steady stream of cash. Studies have shown that from 1972 to 2006, stocks in the S&P 500 that don't pay dividends have earned an average annual return of 4.1%; dividend stocks, however, have averaged a whopping 10.1% per year. That is an incredible difference -- one that you'd be crazy to not take advantage of!

But investing in dividends can be dangerous -- companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warnings signs that may alert you, and these red flags could be the crucial factor in determining whether a company is likely to continue paying its dividend. Today, let's drill beneath the surface and check out Analog Devices (NYSE: ADI  ) .

What's on the surface?
Analog Devices, which operates in the semiconductors industry, currently pays a dividend of 2.73%. That's certainly nothing to sneeze at, as the average dividend payer in the S&P 500 in 2009 sported a yield of 2%.

But what's more important than the dividend itself is Analog Devices' ability to keep that cash rolling. The first thing to look at is the company's reported dividends versus its reported earnings. If you happen to see dividend payments that are growing faster than earnings per share, it may be an initial signal that something just isn't right. Check out the graph below for details of the last five years:

Source: Capital IQ, a division of Standard & Poor's.

Source: Capital IQ, a division of Standard & Poor's.

Clearly, there doesn't seem to be a problem, here. Although there was a significant drop in earnings for about a year, Analog Devices has been able to boost its earnings at an adequate pace and keep its dividends in check at the same time.

The more secure, the better
One of the most common metrics that investors use to judge the safety of a dividend is the payout ratio. This number tells you what percentage of net income is paid out to investors in the form of a dividend. Normally, anything above 50% is cause to look a bit further. According to the most recent data, Analog Devices' payout ratio is 40.95%. It's obvious that, at least on the surface, there aren't any problems with Analog Devices generating enough income to support that nice dividend of 2.73%.

More important than checking out the payout ratio may be simply taking a peek at Analog Devices' cash flow. Free cash flow -- all the cash left over after subtracting out capital expenditures -- is used by firms to make acquisitions, develop new products, and of course, pay dividends! We can use a simple metric called the cash flow coverage ratio, which is cash flow per share divided by dividends per share. Normally, anything above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. Analog Devices' coverage ratio is 3.23, -- which is more than enough cash on hand to keep pumping out that 2.73% yield. Barring any unforeseen circumstances, there really shouldn't be any major problems moving forward.

Either way, it's always beneficial to compare an investment with its most immediate competitors, so in the chart below, I've included the above metrics with those of Analog Devices' closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Analog Devices can illustrate that it's grown dividends over the past five years then there's a good chance that it will continue to put shareholders first in the future. Check out how Analog Devices stacks up below:

Company

Dividend

Yield

Payout

Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

Analog Devices

2.73%

40.95%

3.23

20.71%

Texas Instruments (NYSE: TXN  )

1.79%

19.99%

3.93

36.85%

Linear Technology (Nasdaq: LLTC  )

2.95%

72.55%

1.80

19.08%

Xilinx (Nasdaq: XLNX  )

2.51%

51.49%

2.95

21.67%

Source: Capital IQ, a division of Standard & Poor's.

The Foolish bottom line
Only you can decide what numbers you're comfortable with in the end; sometimes a higher yield and a higher reward mean additional risk. However, when we look at Analog Devices' payout ratio compared to its peer average, we see that it is a lower percentage, which illustrates that its dividend is probably more sustainable. The bottom line, however, is to make sure that with anything -- whether it be a dividend, a share repurchase, or an ordinary earnings report -- you do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.

Jordan DiPietro owns no shares. Linear Technology is a Motley Fool Stock Advisor choice. The Fool owns shares of Texas Instruments. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 29, 2010, at 10:18 AM, cgp62 wrote:

    Good article on how to look deeper than just dividend yield. The title "Analog Devices' Dividends May Not Last Forever?" doesn't mesh with the content. The title leads one to believe that AD may have some problems. The article shows that AD is fairly solid compared to competitors. The Fools disclosure that it owns or touts AD's competition makes one wonder about the choice of the title. It would be interesting to know whether the article author, Jordan DiPietro, or someone else supplied the title.

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