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Do Investors Have Good Reason To Be Wary Of Servcorp Limited's (ASX:SRV) 8.6% Dividend Yield?

Simply Wall St

Is Servcorp Limited (ASX:SRV) a good dividend stock? How would you know? Dividend paying companies with growing earnings can be highly rewarding in the long term. 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 8.6% 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. The company also bought back stock equivalent to around 2.5% of market capitalisation this year. Before you buy any stock for its dividend however, you should always remember Warren Buffett's two rules: 1) Don't lose money, and 2) Remember rule #1. We'll run through some checks below to help with this.

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ASX:SRV Historical Dividend Yield, May 26th 2019

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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. Although it reported a loss over the past 12 months, Servcorp currently pays a dividend. When a company recently reported a loss, we should investigate if its cash flows covered the dividend.

Of the free cash flow it generated last year, Servcorp paid out 48% as dividends, suggesting the dividend is affordable.

Remember, you can always get a snapshot of Servcorp's latest financial position, by checking our visualisation of its financial health.

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. This dividend has been unstable, which we define as having fallen by at least 20% one or more times over this time. During the past ten-year period, the first annual payment was AU$0.25 in 2009, compared to AU$0.26 last year. Dividend payments have grown at less than 1% a year over this period.

It's good to see some dividend growth, but the dividend has been cut at least once, and the size of the cut would eliminate most of the growth, anyway. We're not that enthused by this.

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. It's not great to see that Servcorp's have fallen at approximately 12% over the past five years. If earnings continue to decline, the dividend may come under pressure. Every investor should make an assessment of whether the company is taking steps to stabilise the situation.

Conclusion

To summarise, shareholders should always check that Servcorp's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. We're a bit uncomfortable with the company paying a dividend while being loss-making, although at least the dividend was covered by free cash flow. Earnings per share have been falling, and the company has cut its dividend at least once in the past. From a dividend perspective, this is a cause for concern. In summary, Servcorp has a number of shortcomings that we'd find it hard to get past. Things could change, but we think there are a number of better ideas out there.

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

Looking for more high-yielding dividend ideas? Try our curated list of dividend stocks with a yield above 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.