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Factors Income Investors Should Consider Before Adding Servcorp Limited (ASX:SRV) To Their Portfolio

Simply Wall St

Could Servcorp Limited (ASX:SRV) be an attractive dividend share to own for the long haul? Investors are often drawn to strong companies with the idea of reinvesting the dividends. Unfortunately, it's common for investors to be enticed in by the seemingly attractive yield, and lose money when the company has to cut its dividend payments.

In this case, Servcorp likely looks attractive to investors, given its 4.5% dividend yield and a payment history of over ten years. It would not be a surprise to discover that many investors buy it for the dividends. During the year, the company also conducted a buyback equivalent to around 0.9% of its market capitalisation. Some simple analysis can reduce the risk of holding Servcorp for its dividend, and we'll focus on the most important aspects below.

Click the interactive chart for our full dividend analysis

ASX:SRV Historical Dividend Yield, January 23rd 2020

Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, 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. Servcorp paid out 414% of its profit as dividends, over the trailing twelve month period. A payout ratio above 100% is definitely an item of concern, unless there are some other circumstances that would justify it.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Servcorp paid out a conservative 49% of its free cash flow as dividends last year. It's disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Servcorp fortunately did generate enough cash to fund its dividend. If executives were to continue paying more in dividends than the company reported in profits, we'd view this as a warning sign. Very few companies are able to sustainably pay dividends larger than their reported earnings.

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

We update our data on Servcorp 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 Servcorp's dividend payments. Its dividend payments have declined on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was AU$0.25 in 2010, compared to AU$0.20 last year. The dividend has shrunk at around 2.2% a year during that period. Servcorp's dividend has been cut sharply at least once, so it hasn't fallen by 2.2% every year, but this is a decent approximation of the long term change.

A shrinking dividend over a ten-year period is not ideal, and we'd be concerned about investing in a dividend stock that lacks a solid record of growing dividends per share.

Dividend Growth Potential

Given that the dividend has been cut in the past, we need to check if earnings are growing and if that might lead to stronger dividends in the future. Servcorp's earnings per share have shrunk at 27% a year over the past five years. A sharp decline in earnings per share is not great from from a dividend perspective, as even conservative payout ratios can come under pressure if earnings fall far enough.

Conclusion

Dividend investors should always want to know if a) a company's dividends are affordable, b) if there is a track record of consistent payments, and c) if the dividend is capable of growing. We're a bit uncomfortable with its high payout ratio, although at least the dividend was covered by free cash flow. Second, earnings per share have been in decline, and its dividend has been cut at least once in the past. With this information in mind, we think Servcorp may not be an ideal dividend stock.

Now, if you want to look closer, it would be worth checking out our free research on Servcorp management tenure, salary, and performance.

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