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Investors In McMillan Shakespeare Limited (ASX:MMS) Should Consider This, First

Simply Wall St

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Dividend paying stocks like McMillan Shakespeare Limited (ASX:MMS) 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. If you are hoping to live on your dividends, it's important to be more stringent with your investments than the average punter. Regular readers know we like to apply the same approach to each dividend stock, and we hope you'll find our analysis useful.

With McMillan Shakespeare yielding 5.5% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. It would not be a surprise to discover that many investors buy it for the dividends. Some simple research can reduce the risk of buying McMillan Shakespeare for its dividend - read on to learn more.

Explore this interactive chart for our latest analysis on McMillan Shakespeare!

ASX:MMS Historical Dividend Yield, July 20th 2019

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. 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, McMillan Shakespeare paid out 123% of its profit as dividends. A payout ratio above 100% is definitely an item of concern, unless there are some other circumstances that would justify it.

We also measure dividends paid against a company's levered free cash flow, to see if enough cash was generated to cover the dividend. McMillan Shakespeare paid out 55% of its free cash flow last year, which is acceptable, but is starting to limit the amount of earnings that can be reinvested into the business. It's good to see that while McMillan Shakespeare's dividends were not covered by profits, at least they are affordable from a cash perspective. Still, if the company repeatedly paid a dividend greater than its profits, we'd be concerned. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.

Is McMillan Shakespeare's Balance Sheet Risky?

As McMillan Shakespeare'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 measures total debt load relative to company earnings (lower = less debt), while net interest cover measures the ability to pay interest on the debt (higher = greater ability to pay interest costs). McMillan Shakespeare has net debt of 1.20 times its EBITDA, which we think is not too troublesome.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 14.24 times its interest expense, McMillan Shakespeare's interest cover is quite strong - more than enough to cover the interest expense.

We update our data on McMillan Shakespeare every 24 hours, so you can always get our latest analysis of its financial health, here.

Dividend Volatility

Before buying a stock for its income, we want to see if the dividends have been stable in the past, and if the company has a track record of maintaining its dividend. For the purpose of this article, we only scrutinise the last decade of McMillan Shakespeare'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$0.17 in 2009, compared to AU$0.74 last year. This works out to be a compound annual growth rate (CAGR) of approximately 16% a year over that time. The growth in dividends has not been linear, but the CAGR is a decent approximation of the rate of change over this time frame.

It's not great to see that the payment has been cut in the past. We're generally more wary of companies that have cut their dividend before, as they tend to perform worse in an economic downturn.

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 McMillan Shakespeare's have fallen at approximately 6.3% over the past five years. Declining earnings per share over a number of years is not a great sign for the dividend investor. Without some improvement, this does not bode well for the long term value of a company's dividend.

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 not keen on the fact that McMillan Shakespeare paid out such a high percentage of its income, although its cashflow is in better shape. Earnings per share are down, and McMillan Shakespeare's dividend has been cut at least once in the past, which is disappointing. There are a few too many issues for us to get comfortable with McMillan Shakespeare from a dividend perspective. Businesses can change, but we would struggle to identify why an investor should rely on this stock for their income.

Given that earnings are not growing, the dividend does not look nearly so attractive. Very few businesses see earnings consistently shrink year after year in perpetuity though, and so it might be worth seeing what the 5 analysts we track are forecasting for the future.

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