High dividend yield? It might be a bad sign. In this short video, learn a rule of thumb to tell the difference between value plays and value traps, plus hear about a top TSX dividend stock that looks undervalued right now.
Prefer to read? There’s a transcript below.
Transcript
Nick Sciple: I’m Motley Fool Canada senior analyst Nick Sciple, and this is the “Five-Minute Major,” here to make you a smarter investor in about five minutes. Today we’ll share a few things to look at when evaluating dividend stocks and close with one Canadian dividend stock that looks undervalued right now. My guest today is Motley Fool Canada Chief Investment Officer Iain Butler. Iain, thanks for joining me.
Iain Butler: Great to be here, Nick, as always.
Value play vs value trap
Nick: So we’re talking dividend stocks today, Iain, specifically undervalued dividend stocks. When you’re looking at a dividend stock for the first time, how do you separate a value play from a company that’s a value trap?
Iain: It’s a great question. And I think a lot of people actually do get hung up on this. So we’ll try and shed some light here. One tell that I’d highlight is when you see a sky-high dividend yield. That’s an indication, I think a pretty good indication, that you’re looking at a value trap. I can recall a study done by Bernstein Research 10 or 15 years ago — I’m pretty sure it holds up — that indicated a dividend yield north of 8% is a warning signal, and I think that’s pretty darn solid rule of thumb to follow when it comes to identifying value traps in the dividend sphere. Too good to be true is definitely a thing when it comes to investing. And frankly, the market is pretty darn good at deciphering cans and cannots when it comes to affording dividend payments. So it’s not like the market’s giving you anything for free here.
Financial red flags with dividend stocks
To dig a bit deeper, though, if you use that as a flag, then turn to the company’s financials, namely, the company’s cash flow statement and its balance sheet, you can glean some further insight there on the cash flow statement. What you want to do is have a look at free cash flow, which is cash from operations minus a company’s capital expenditures.
You want to compare that number to the company’s ongoing dividend obligation. So say a company’s earning $100 in free cash flow and paying out $70 in dividends. That’s a reasonable indication that the company is capable of handling that dividend. You want to string a few years together just to make sure. That’s a good indication if the company is paying out more than $100. Then again, you’re looking at value trap territory. On the balance sheet, you just want to see about debt. Debt comes before all other obligations for companies, so should they stub their toe at some point, they are obliged to fulfill their lenders through interest payments and principal repayments before people receive their dividends. So we’ve seen this as a cause of many dividend cuts over the years. I can think of any number of companies that have run into balance sheet problems and had to cut their dividend to appease their lenders. So those are some things to look for, a red flag: high dividend yield and then just a couple quick metrics on the financial statements.
1 smart TSX dividend stock to buy today
Nick: So with that in mind, what’s one dividend stock that you think looks undervalued right now?
Iain: The company that comes to mind for me is one that we’ve we’ve talked a lot about over the years amongst the Canadian investing team. It was one of our original recommendations in Stock Advisor Canada, and the company is called MTY Food Group (TSX: MTY).
People may not know MTY Food Group, but I suspect that they know some of the 80 different brands across Canada and the United States that MTY Food Group owns. It’s quick-service, fast-casual, and casual dining restaurants and names such as Baton Rouge, Thai Express, Mr. Sub, Papa Murphy’s, Cold Stone Creamery, Country Style and Cultures are all part of what make up MTY Food Group. MTY Food Group collects royalties from these restaurants. And it’s a wonderful model when it comes to generating free cash flow. Historically, it was not a dividend payer. The company introduced a dividend a few years ago. The stock currently yields 3.2%, which is at the very high end of its all-time range. It generated about $180 million in free cash flow. Remember, this is an important metric to look for. $180 million in free cash flow over the past 12 months. Annual dividend obligation of $27 million, so very, very capable of covering its dividend obligation. It’s been acquisitive over the years. They haven’t been acquisitive in recent years, focused on paying down debt, but they’ve also been buying back a lot of stock, and this dividend has grown steadily over the past four or five years.
This is not a yield that jumps off the page at 3.2%. But it is a dividend that’s grown, and we expect it will continue to grow. And this is a company that I think you can buy today at a really reasonable price and be quite happy in five years’ time with the total return that it provides.
Nick: That’s right. I mean, it’s often forgotten that your initial yield on a company — especially for a company that can grow its free cash flow — that distribution isn’t what your yield is going to look like in year two and year three and year four. For somebody who’s investing over the long term like we advocate at Motley Fool Canada, that is an important part of the calculus of the value of the company today versus where you think the business can be over the long term.
Iain, thanks for joining us for this edition of the Five-Minute Major. Look forward to seeing you next time.
Iain: Good stuff. Thanks, Nick.
