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Could American Electric Power Company, Inc. (NYSE:AEP) Have The Makings Of Another Dividend Aristocrat?

Simply Wall St

Dividend paying stocks like American Electric Power Company, Inc. (NYSE:AEP) tend to be popular with investors, and for good reason - some research suggests a significant amount of all stock market returns come from reinvested dividends. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.

In this case, American Electric Power Company likely looks attractive to investors, given its 3.9% dividend yield and a payment history of over ten years. It would not be a surprise to discover that many investors buy it for the dividends. Some simple analysis can reduce the risk of holding American Electric Power Company for its dividend, and we'll focus on the most important aspects below.

Click the interactive chart for our full dividend analysis

NYSE:AEP Historical Dividend Yield April 7th 2020

Payout ratios

Companies (usually) pay dividends out of their earnings. If a company is paying more than it earns, the dividend might have to be cut. As a result, we should always investigate whether a company can afford its dividend, measured as a percentage of a company's net income after tax. American Electric Power Company paid out 70% of its profit as dividends, over the trailing twelve month period. This is a healthy payout ratio, and while it does limit the amount of earnings that can be reinvested in the business, there is also some room to lift the payout ratio over time.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Last year, American Electric Power Company paid a dividend while reporting negative free cash flow. While there may be an explanation, we think this behaviour is generally not sustainable.

Is American Electric Power Company's Balance Sheet Risky?

As American Electric Power Company has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick check of its financial situation can be done with two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. American Electric Power Company has net debt of 5.64 times its EBITDA, which implies meaningful risk if interest rates rise of earnings decline.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 2.67 times its interest expense, American Electric Power Company's interest cover is starting to look a bit thin. High debt and weak interest cover are not a great combo, and we would be cautious of relying on this company's dividend while these metrics persist.

We update our data on American Electric Power Company every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. For the purpose of this article, we only scrutinise the last decade of American Electric Power Company's dividend payments. The dividend has been stable over the past 10 years, which is great. We think this could suggest some resilience to the business and its dividends. During the past ten-year period, the first annual payment was US$1.64 in 2010, compared to US$2.80 last year. This works out to be a compound annual growth rate (CAGR) of approximately 5.5% a year over that time.

Companies like this, growing their dividend at a decent rate, can be very valuable over the long term, if the rate of growth can be maintained.

Dividend Growth Potential

Dividend payments have been consistent over the past few years, but we should always check if earnings per share (EPS) are growing, as this will help maintain the purchasing power of the dividend. Earnings have grown at around 3.7% a year for the past five years, which is better than seeing them shrink! 3.7% per annum is not a particularly high rate of growth, which we find curious. When a business is not growing, it often makes more sense to pay higher dividends to shareholders rather than retain the cash with no way to utilise it.

Conclusion

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. First, the company has a payout ratio that was within an average range for most dividend stocks, but it paid out virtually all of its generated cash flow. Second, earnings growth has been mediocre, but at least the dividends have been relatively stable. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than American Electric Power Company out there.

Market movements attest to how highly valued a consistent dividend policy is compared to one which is more unpredictable. However, there are other things to consider for investors when analysing stock performance. Just as an example, we've come accross 2 warning signs for American Electric Power Company you should be aware of, and 1 of them doesn't sit too well with us.

We have also put together a list of global stocks with a market capitalisation above $1bn and yielding more 3%.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.