Building a passive income through dividend stocks can be incredibly successful if investors can choose the right companies over the long term. However, many companies offering a high yield often perform poorly in the market, offsetting any gains from the dividend.
I’m going to take retirement and savings giant Phoenix Group (LSE:PHNX) as an example, pointing out what I look out for before investing in such companies.
The numbers
I take a holistic view when thinking about dividend-paying companies. The dividend itself is important, but if the company is not able to continue paying the dividend for the foreseeable future, then it’s not for me.
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The first metric I tend to look at is profitability. In an environment where interest rates are high, and the appetite for risk-taking is greatly reduced, an unsustainable business model is unlikely to attract investors. I need to see a clear path to profit, and sustainable growth.
Phoenix Group is currently unprofitable, losing over £800m in the last year. Losses have increased over the last five years by 62% annually, far below the 7.1% average annual loss of the sector.
One metric which really stands out to me, however, is the future growth rate, which suggests earnings will grow at 91% over the coming years, well above the sector average of 19%. This growth is expected to lead to profitability for Phoenix in the next three years.
Dividend stability
Obviously, the 10.5% dividend is the clear attraction when it comes to this investment. Many companies might have reduced this yield to progress towards profitability. Nevertheless, Phoenix’s dividend has been steadily growing over the last decade. The company is also forecasting further increases over the coming years.
This is clearly a sign of confidence. However, with a payout ratio of -63%, which reflects the level of earnings paid out as dividends, things are already looking rather stretched.
Debt levels
In the near term, there are more liabilities than assets on the balance sheet. This suggests that there could well be some volatility and unpredictability ahead. Fortunately, the longer-term view is more optimistic, with considerably more assets than liabilities, attributed to large cash reserves. As a result, the business would theoretically be able to continue operations for three years even without income. This could potentially reassure investors with near-term concerns.
Valuation
Understanding future cash flows is critical in order to estimate the fair value of shares. I like to use a discounted cash flow calculation to do so. At present, the shares of the company are estimated to be about 26% below fair value of £6.58, but this is far from guaranteed. The price-to-earnings (P/E) ratio of 1.5 times is fairly well aligned to the average of the sector at 1.6 times.
Am I buying?
Clearly Phoenix Group is looking to turn things around after a difficult few years. Taking heavy losses with a high dividend can be a recipe for disaster. However, if growth can be delivered at the rates expected, good times may yet be ahead for investors. For me, with uncertainty still rife in the economy, I don’t want to take a chance on a dividend stock with such a major turnaround to do.
