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Psychemedics Corporation (NASDAQ:PMD) Investors Should Think About This Before Buying It For Its Dividend

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Simply Wall St
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Today we'll take a closer look at Psychemedics Corporation (NASDAQ:PMD) from a dividend investor's perspective. Owning a strong business and reinvesting the dividends is widely seen as an attractive way of growing your wealth. If you are hoping to live on the income from dividends, it's important to be a lot more stringent with your investments than the average punter.

With Psychemedics yielding 7.8% and having paid a dividend for over 10 years, many investors likely find the company quite interesting. We'd guess that plenty of investors have purchased it for the income. There are a few simple ways to reduce the risks of buying Psychemedics for its dividend, and we'll go through these below.

Click the interactive chart for our full dividend analysis

NasdaqCM:PMD Historical Dividend Yield, December 13th 2019
NasdaqCM:PMD Historical Dividend Yield, December 13th 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. 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, Psychemedics paid out 134% 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. Psychemedics paid out 67% 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 disappointing to see that the dividend was not covered by profits, but cash is more important from a dividend sustainability perspective, and Psychemedics 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. Extraordinarily few companies are capable of persistently paying a dividend that is greater than their profits.

With a strong net cash balance, Psychemedics investors may not have much to worry about in the near term from a dividend perspective.

Consider getting our latest analysis on Psychemedics's financial position 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 Psychemedics's dividend payments. Its dividend payments have fallen by 20% or more on at least one occasion over the past ten years. During the past ten-year period, the first annual payment was US$0.68 in 2009, compared to US$0.72 last year. Its dividends have grown at less than 1% per annum over this time frame.

Modest growth in the dividend is good to see, but we think this is offset by historical cuts to the payments. It is hard to live on a dividend income if the company's earnings are not consistent.

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. In the last five years, Psychemedics's earnings per share have shrunk at approximately 5.7% per annum. 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

When we look at a dividend stock, we need to form a judgement on whether the dividend will grow, if the company is able to maintain it in a wide range of economic circumstances, and if the dividend payout is sustainable. We're not keen on the fact that Psychemedics paid out such a high percentage of its income, although its cashflow is in better shape. 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. There are a few too many issues for us to get comfortable with Psychemedics from a dividend perspective. Businesses can change, but we would struggle to identify why an investor should rely on this stock for their income.

See if management have their own wealth at stake, by checking insider shareholdings in Psychemedics stock.

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.