One measure of a great dividend stock is the sustainability of its payout. When the percentage of a company's income paid out to shareholders as dividends gets too high for too long, it's a clear indicator of trouble. When the payout ratio tops 100%, the company is dipping into cash balances (or even go into short-term debt) to pay those dividends. Eventually, it will be forced to reduce or suspend the payout.
Another measure of a great dividend stock is whether the company is growing its base of repeat customers. This suggests the customers highly value the company's products and services. It also helps the company increase revenue and net earnings over the long run. That consistency helps it maintain dividend payouts and maybe even increase its dividends without adversely altering the dividend payout ratio.
E-commerce giant Amazon (AMZN 3.43%) does not currently pay a dividend. But based on these measures, it certainly has real potential to be a great dividend stock. Let me explain why.
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The top priority at the moment is investing in growth
As already noted, dividend-paying businesses generally pay for those dividends out of their earnings. What I didn't note was that it's often from earnings that the company doesn't already have some other use for. Companies have several options when deciding what to do with their net earnings.
One option is to invest in growth opportunities, and that is something that Amazon is doing quite aggressively. Amazon's total net income for the last three years was $43 billion. Over that same time frame, Amazon spent $59 billion on property, plants, and equipment -- more commonly referred to as capital investments. Amazon is so focused on expansion efforts that it actually dipped into its savings to finance its various growth opportunities. Those investments are bearing fruit.
Amazon is doing well to self-fund these expansion efforts. It has increased earnings per share at a compound annual rate of 32.4% over the last decade. Its net debt rate is only about $3.15 billion, and it is easily manageable considering Amazon's yearly gross revenue was about $386 billion in 2020.
As long as it can find lucrative expansion opportunities, Amazon will continue to reinvest earnings there. Eventually, though, the e-commerce giant will reach a point where total earnings are consistently more than it can find places to allocate it. That is when management might start considering paying out dividends.
A dividend stock eventually?
Amazon is increasing revenue as well as net earnings at a rapid rate. When it reaches the point where it has cash beyond profitable growth opportunities, I strongly suspect it will begin returning that leftover cash to shareholders.
Interestingly, the longer it takes to reach this point, the better it may be for investors looking for dividends. That would mean Amazon is continuing to find profitable areas for growth and it can lead to bigger and more sustainable dividends in the long run.
It may not be a great dividend stock at the moment, but Amazon has strong potential to become one in the future.
