It Might Not Be A Great Idea To Buy Diageo plc (LON:DGE) For Its Next Dividend

Diageo plc (LON:DGE) stock is about to trade ex-dividend in three days. If you purchase the stock on or after the 13th of August, you won't be eligible to receive this dividend, when it is paid on the 8th of October.

Diageo's upcoming dividend is UK£0.42 a share, following on from the last 12 months, when the company distributed a total of UK£0.70 per share to shareholders. Last year's total dividend payments show that Diageo has a trailing yield of 2.7% on the current share price of £25.67. We love seeing companies pay a dividend, but it's also important to be sure that laying the golden eggs isn't going to kill our golden goose! We need to see whether the dividend is covered by earnings and if it's growing.

Check out our latest analysis for Diageo

Dividends are usually paid out of company profits, so if a company pays out more than it earned then its dividend is usually at greater risk of being cut. Diageo distributed an unsustainably high 116% of its profit as dividends to shareholders last year. Without more sustainable payment behaviour, the dividend looks precarious. That said, even highly profitable companies sometimes might not generate enough cash to pay the dividend, which is why we should always check if the dividend is covered by cash flow. The company paid out 102% of its free cash flow over the last year, which we think is outside the ideal range for most businesses. Cash flows are usually much more volatile than earnings, so this could be a temporary effect - but we'd generally want look more closely here.

Cash is slightly more important than profit from a dividend perspective, but given Diageo's payments were not well covered by either earnings or cash flow, we are concerned about the sustainability of this dividend.

Click here to see the company's payout ratio, plus analyst estimates of its future dividends.

Have Earnings And Dividends Been Growing?

Businesses with shrinking earnings are tricky from a dividend perspective. Investors love dividends, so if earnings fall and the dividend is reduced, expect a stock to be sold off heavily at the same time. Diageo's earnings per share have fallen at approximately 8.8% a year over the previous five years. When earnings per share fall, the maximum amount of dividends that can be paid also falls.

Another key way to measure a company's dividend prospects is by measuring its historical rate of dividend growth. In the past 10 years, Diageo has increased its dividend at approximately 6.8% a year on average. The only way to pay higher dividends when earnings are shrinking is either to pay out a larger percentage of profits, spend cash from the balance sheet, or borrow the money. Diageo is already paying out a high percentage of its income, so without earnings growth, we're doubtful of whether this dividend will grow much in the future.

The Bottom Line

Is Diageo an attractive dividend stock, or better left on the shelf? It's looking like an unattractive opportunity, with its earnings per share declining, while, paying out an uncomfortably high percentage of both its profits (116%) and cash flow as dividends. This is a clearly suboptimal combination that usually suggests the dividend is at risk of being cut. If not now, then perhaps in the future. It's not that we think Diageo is a bad company, but these characteristics don't generally lead to outstanding dividend performance.

With that in mind though, if the poor dividend characteristics of Diageo don't faze you, it's worth being mindful of the risks involved with this business. To that end, you should learn about the 4 warning signs we've spotted with Diageo (including 1 which is potentially serious).

We wouldn't recommend just buying the first dividend stock you see, though. Here's a list of interesting dividend stocks with a greater than 2% yield and an upcoming dividend.

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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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