If you are considering buying a stock purely for its dividend yield, then you will want to be sure that the dividend can grow in the future. As such, it's not simply a question of picking out a high-yield stock and sticking with it in the long term. Usually, investors will want to make a qualitative analysis of the stock, and quite often, a quantitative analysis. Not least because the numbers often demonstrate the underlying trends in a company's business.
With this in mind, here are three essential checks that you should make before buying a stock for its yield.
1. Profit margin trends
This is one of the most important metrics in all of investing. The trend in profit margin tells you a lot of what you need to know about a stock. You can make a case for a low-margin company because its margin will improve. You can make a case for a high-margin company on the basis that its margin can be sustained. But it's tough to make a case for a stock with a declining profit margin.
Declining profit margins put pressure on a company's ability to generate the earnings and cash flow necessary to increase dividend payments.
3M's EBITDA margin decline before 2020 is a concern. The margin expansion in recent quarters has been partly due to selling more higher-margin safety products during the pandemic. AT&T's margin trend is also a concern. However, the long-term downtrend in MSC Industrial's margin is a real concern, and it suggests that something structurally unfavorable is happening in its end markets. It may well be that the growth of online competition is challenging MSC Industrial's pricing power.
2. Return on equity
This is a measure of net income divided by shareholders' equity, where shareholders' equity is a company's assets minus its liabilities. Return on equity (RoE) measures how much profit a company generates from its net assets.
A higher number is better, but you also need to focus on the trend. 3M's RoE is excellent; it does a good job of converting shareholders' equity into profits. MSC's is fine but seems to be on the decline somewhat. However, AT&T's declining RoE is a real concern and speaks to the issues it's had with its acquisition of DIRECTV in 2015, precisely when the pay-TV market began to fall.
3. Dividends from free cash flow
Free cash flow (FCF) is what's left from earnings after working capital requirements and capital spending have been taken out. It represents the flow of cash in a year that a company can use to pay off debt, buy back stock, make acquisitions, or pay dividends. As such, it's important for a company not to be paying too much of its FCF in dividends. Also, a low ratio of dividend per share (DPS) to FCF gives scope for dividend increases in the future.
As a rough rule of thumb, a company paying more than 60% of its FCF in dividends is probably high. 3M has been above that level in recent years, but its high RoE suggests it can generate good returns from the FCF it's not spending on its dividend. That's might not be the case for AT&T because it has a low RoE.
Putting it all together
All told, MSC Industrial's declining margin excludes it from being a candidate. At the same time, AT&T's combination of a moderately high DPS/FCF ratio combined with poor RoE means investors should ignore the immediate attraction of its 6.6% dividend yield. The quantitative data around these two companies suggest they may well have some sort of structural problem in their businesses.
The most intriguing prospect is 3M. If the company's restructuring program works and management can get EBITDA margin moving in the right direction after the pandemic eases, then investors could be holding a very high RoE stock. Moreover, its dividend is well covered by its FCF, so management has plenty of potential to raise its dividend for many years to come.