Don't Race Out To Buy Contact Energy Limited (NZSE:CEN) Just Because It's Going Ex-Dividend

Contact Energy Limited (NZSE:CEN) stock is about to trade ex-dividend in 4 days. The ex-dividend date is two business days before a company's record date in most cases, which is the date on which the company determines which shareholders are entitled to receive a dividend. The ex-dividend date is an important date to be aware of as any purchase of the stock made on or after this date might mean a late settlement that doesn't show on the record date. Therefore, if you purchase Contact Energy's shares on or after the 17th of August, you won't be eligible to receive the dividend, when it is paid on the 23rd of September.

The company's next dividend payment will be NZ$0.2735294 per share. Last year, in total, the company distributed NZ$0.40 to shareholders. Based on the last year's worth of payments, Contact Energy stock has a trailing yield of around 4.4% on the current share price of NZ$9.03. If you buy this business for its dividend, you should have an idea of whether Contact Energy's dividend is reliable and sustainable. That's why we should always check whether the dividend payments appear sustainable, and if the company is growing.

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Dividends are typically paid from company earnings. If a company pays more in dividends than it earned in profit, then the dividend could be unsustainable. Contact Energy paid out 96% of its earnings, which is more than we're comfortable with, unless there are mitigating circumstances. Yet cash flow is typically more important than profit for assessing dividend sustainability, so we should always check if the company generated enough cash to afford its dividend. The company paid out 98% of its free cash flow over the last year, which we think is outside the ideal range for most businesses. Companies usually need cash more than they need earnings - expenses don't pay themselves - so it's not great to see it paying out so much of its cash flow.

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

See our latest analysis for Contact Energy

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

Have Earnings And Dividends Been Growing?

Stocks in companies that generate sustainable earnings growth often make the best dividend prospects, as it is easier to lift the dividend when earnings are rising. If earnings fall far enough, the company could be forced to cut its dividend. With that in mind, we're encouraged by the steady growth at Contact Energy, with earnings per share up 9.2% on average over the last five years. Earnings per share have been growing steadily, although a payout ratio this high suggests future growth is likely to slow, and the dividend may also be at risk of a cut if business enters a downturn.

Contact Energy also issued more than 5% of its market cap in new stock during the past year, which we feel is likely to hurt its dividend prospects in the long run. Trying to grow the dividend while issuing large amounts of new shares reminds us of the ancient Greek tale of Sisyphus - perpetually pushing a boulder uphill.

Another key way to measure a company's dividend prospects is by measuring its historical rate of dividend growth. In the past 10 years, Contact Energy has increased its dividend at approximately 4.4% a year on average. It's encouraging to see the company lifting dividends while earnings are growing, suggesting at least some corporate interest in rewarding shareholders.

The Bottom Line

Is Contact Energy worth buying for its dividend? The dividends are not well covered by either income or free cash flow, although at least earnings per share are slowly increasing. It's not that we think Contact Energy is a bad company, but these characteristics don't generally lead to outstanding dividend performance.

Although, if you're still interested in Contact Energy and want to know more, you'll find it very useful to know what risks this stock faces. Every company has risks, and we've spotted 2 warning signs for Contact Energy (of which 1 can't be ignored!) you should know about.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.