Advance Auto Parts, Inc. (NYSE:AAP) will pay a dividend of $0.25 on the 24th of January. Based on this payment, the dividend yield on the company's stock will be 2.7%, which is an attractive boost to shareholder returns.

While the dividend yield is important for income investors, it is also important to consider any large share price moves, as this will generally outweigh any gains from distributions. Advance Auto Parts' stock price has reduced by 38% in the last 3 months, which is not ideal for investors and can explain a sharp increase in the dividend yield.

View our latest analysis for Advance Auto Parts

Advance Auto Parts' Future Dividend Projections Appear Well Covered By Earnings

A big dividend yield for a few years doesn't mean much if it can't be sustained. Before making this announcement, Advance Auto Parts' dividend was higher than its profits, but the free cash flows quite comfortably covered it. Given that the dividend is a cash outflow, we think that cash is more important than accounting measures of profit when assessing the dividend, so this is a mitigating factor.

Looking forward, earnings per share is forecast to rise exponentially over the next year. If the dividend continues along recent trends, we estimate the payout ratio will be 29%, which would make us comfortable with the dividend's sustainability, despite the levels currently being elevated.

Dividend Volatility

The company has a long dividend track record, but it doesn't look great with cuts in the past. The annual payment during the last 10 years was $0.24 in 2014, and the most recent fiscal year payment was $1.00. This works out to be a compound annual growth rate (CAGR) of approximately 15% a year over that time. It is great to see strong growth in the dividend payments, but cuts are concerning as it may indicate the payout policy is too ambitious.

Dividend Growth Potential Is Shaky

With a relatively unstable dividend, it's even more important to see if earnings per share is growing. Advance Auto Parts' earnings per share has shrunk at 34% a year over the past five years. This steep decline can indicate that the business is going through a tough time, which could constrain its ability to pay a larger dividend each year in the future. However, the next year is actually looking up, with earnings set to rise. We would just wait until it becomes a pattern before getting too excited.

The Dividend Could Prove To Be Unreliable

Overall, it's nice to see a consistent dividend payment, but we think that longer term, the current level of payment might be unsustainable. The company is generating plenty of cash, which could maintain the dividend for a while, but the track record hasn't been great. We don't think Advance Auto Parts is a great stock to add to your portfolio if income is your focus.

Investors generally tend to favour companies with a consistent, stable dividend policy as opposed to those operating an irregular one. Still, investors need to consider a host of other factors, apart from dividend payments, when analysing a company. For example, we've identified 3 warning signs for Advance Auto Parts (1 shouldn't be ignored!) that you should be aware of before investing. If you are a dividend investor, you might also want to look at our curated list of high yield dividend stocks.

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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.