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Should You Buy Extended Stay America, Inc. (NASDAQ:STAY) For Its Dividend?

Simply Wall St

Is Extended Stay America, Inc. (NASDAQ:STAY) a good dividend stock? How can we tell? Dividend paying companies with growing earnings can be highly rewarding in the long term. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

In this case, Extended Stay America likely looks attractive to dividend investors, given its 7.2% dividend yield and six-year payment history. We'd agree the yield does look enticing. The company also bought back stock during the year, equivalent to approximately 2.8% of the company's market capitalisation at the time. Some simple analysis can offer a lot of insights when buying a company for its dividend, and we'll go through this below.

Click the interactive chart for our full dividend analysis

NasdaqGS:STAY Historical Dividend Yield, February 11th 2020

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. 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. In the last year, Extended Stay America paid out 95% of its profit as dividends. This is quite a high payout ratio that suggests the dividend is not well covered by earnings.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. With a cash payout ratio of 100%, Extended Stay America's dividend payments are poorly covered by cash flow. As Extended Stay America's dividend was not well covered by either earnings or cash flow, we would be concerned that this dividend could be at risk over the long term.

Is Extended Stay America's Balance Sheet Risky?

As Extended Stay America's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A rough way to check this is with these two simple ratios: a) net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and b) 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. Extended Stay America has net debt of 3.99 times its EBITDA, which is getting towards the limit of most investors' comfort zones. Judicious use of debt can enhance shareholder returns, but also adds to the risk if something goes awry.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Interest cover of 2.92 times its interest expense is starting to become a concern for Extended Stay America, and be aware that lenders may place additional restrictions on the company as well.

Consider getting our latest analysis on Extended Stay America's financial position here.

Dividend Volatility

One of the major risks of relying on dividend income, is the potential for a company to struggle financially and cut its dividend. Not only is your income cut, but the value of your investment declines as well - nasty. Extended Stay America has been paying a dividend for the past six years. Its dividend has not fluctuated much that time, which we like, but we're conscious that the company might not yet have a track record of maintaining dividends in all economic conditions. During the past six-year period, the first annual payment was US$0.60 in 2014, compared to US$0.92 last year. Dividends per share have grown at approximately 7.4% per year over this time.

Extended Stay America has been growing its dividend at a decent rate, and the payments have been stable despite the short payment history. This is a positive start.

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. It's good to see Extended Stay America has been growing its earnings per share at 15% a year over the past five years. While EPS are growing rapidly, Extended Stay America paid out a very high 95% of its income as dividends. If earnings continue to grow, this dividend may be sustainable, but we think a payout this high definitely bears watching.

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. Extended Stay America paid out almost all of its cash flow and profit as dividends, leaving little to reinvest in the business. We were also glad to see it growing earnings, although its dividend history is not as long as we'd like. Overall, Extended Stay America falls short in several key areas here. Unless the investor has strong grounds for an alternative conclusion, we find it hard to get interested in a dividend stock with these characteristics.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 10 analysts we track are forecasting for Extended Stay America for free with public analyst estimates for the company.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 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.