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Know This Before Buying Severn Trent Plc (LON:SVT) For Its Dividend

Simply Wall St

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Dividend paying stocks like Severn Trent Plc (LON:SVT) 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.

With Severn Trent yielding 4.6% 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 analysis can reduce the risk of holding Severn Trent for its dividend, and we'll focus on the most important aspects below.

Click the interactive chart for our full dividend analysis

LSE:SVT Historical Dividend Yield, June 17th 2019

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. 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. In the last year, Severn Trent paid out 70% of its profit as dividends. This is a fairly normal payout ratio among most businesses. It allows a higher dividend to be paid to shareholders, but does limit the capital retained in the business - which could be good or bad.

In addition to comparing dividends against profits, we should inspect whether the company generated enough cash to pay its dividend. Last year, Severn Trent paid a dividend while reporting negative free cash flow. While there may be an explanation, we think this behaviour is generally not sustainable. It's encouraging to see that the dividend is covered by both profit and cash flow. This generally suggests the dividend is sustainable, as long as earnings don't drop precipitously.

Is Severn Trent's Balance Sheet Risky?

As Severn Trent has a meaningful amount of debt, we need to check its balance sheet to see if the company might have debt risks. A quick way to check a company's financial situation uses these two ratios: net debt divided by EBITDA (earnings before interest, tax, depreciation and amortisation), and net interest cover. Net debt to EBITDA is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments on debt. Essentially we check that a) a company does not have too much debt, and b) that it can afford to pay the interest. With net debt of more than 5x EBITDA, Severn Trent could be described as a highly leveraged company. While some companies can handle this level of leverage, we'd be concerned about the dividend sustainability if there was any risk of an earnings downturn.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this by the company's net interest expense. Interest cover of less than 5x its interest expense is starting to become a concern for Severn Trent, and be aware that lenders may place additional restrictions on the company as well. Low interest cover and high debt can create problems right when the investor least needs them. We're generally reluctant to rely on the dividend of companies with these traits.

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

Dividend Volatility

From the perspective of an income investor who wants to earn dividends for many years, there is not much point buying a stock if its dividend is regularly cut or is not reliable. For the purpose of this article, we only scrutinise the last decade of Severn Trent'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 UK£0.67 in 2009, compared to UK£0.93 last year. This works out to be a compound annual growth rate (CAGR) of approximately 3.3% a year over that time.

Dividends have grown relatively slowly, which is not great, but some investors may value the relative consistency of the dividend.

Dividend Growth Potential

While dividend payments have been relatively reliable, it would also be nice if earnings per share (EPS) were growing, as this is essential to maintaining the dividend's purchasing power over the long term. In the last five years, Severn Trent's earnings per share have shrunk at approximately 7.6% per annum. 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. First, we think Severn Trent has an acceptable payout ratio, although its dividend was not well covered by cashflow. Moreover, earnings have been shrinking. While the dividends have been fairly steady, we'd wonder for how much longer this will be sustainable if earnings continue to decline. With this information in mind, we think Severn Trent may not be an ideal dividend stock.

Given that earnings are not growing, the dividend does not look nearly so attractive. Businesses can change though, and we think it would make sense to see what analysts are forecasting 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.