Dividend paying stocks like Castrol India Limited (NSE:CASTROLIND) 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. Yet sometimes, investors buy a stock for its dividend and lose money because the share price falls by more than they earned in dividend payments.

A high yield and a long history of paying dividends is an appealing combination for Castrol India. We'd guess that plenty of investors have purchased it for the income. Some simple analysis can reduce the risk of holding Castrol India for its dividend, and we'll focus on the most important aspects below.

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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. So we need to form a view on if a company's dividend is sustainable, relative to its net profit after tax. In the last year, Castrol India paid out 68% of its profit as dividends. A payout ratio above 50% generally implies a business is reaching maturity, although it is still possible to reinvest in the business or increase the dividend over time.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Castrol India paid out 108% of its free cash last year. Cash flows can be lumpy, but this dividend was not well covered by cash flow. While Castrol India's dividends were covered by the company's reported profits, free cash flow is somewhat more important, so it's not great to see that the company didn't generate enough cash to pay its dividend. Cash is king, as they say, and were Castrol India to repeatedly pay dividends that aren't well covered by cashflow, we would consider this a warning sign.

While the above analysis focuses on dividends relative to a company's earnings, we do note Castrol India's strong net cash position, which will let it pay larger dividends for a time, should it choose.

We update our data on Castrol India every 24 hours, so you can always get our latest analysis of its financial health, 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. For the purpose of this article, we only scrutinise the last decade of Castrol India's dividend payments. During this period the dividend has been stable, which could imply the business could have relatively consistent earnings power. During the past ten-year period, the first annual payment was ₹1.88 in 2009, compared to ₹5.25 last year. This works out to be a compound annual growth rate (CAGR) of approximately 11% a year over that time.

It's rare to find a company that has grown its dividends rapidly over ten years and not had any notable cuts, but Castrol India has done it, which we really like.

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 8.6% a year for the past five years, which is better than seeing them shrink! Earnings per share are growing at an acceptable rate, although the company is paying out more than half of its profits, which we think could constrain its ability to reinvest in its business.

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. Castrol India gets a pass on its dividend payout ratio, but it paid out virtually all of its cash flow as dividends. This may just be a one-off, but we'd keep an eye on this. We like that it has been delivering solid improvement in its earnings per share, and relatively consistent dividend payments. In sum, we find it hard to get excited about Castrol India from a dividend perspective. It's not that we think it's a bad business; just that there are other companies that perform better on these criteria.

Earnings growth generally bodes well for the future value of company dividend payments. See if the 8 Castrol India analysts we track are forecasting continued growth with our free report on analyst estimates for the company.

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

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.

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. Thank you for reading.