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Should Severn Trent Plc (LON:SVT) Be Part Of Your Income Portfolio?

Simply Wall St

Could Severn Trent Plc (LON:SVT) 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. 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 Severn Trent yielding 4.1% 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. 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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LSE:SVT Historical Dividend Yield, November 28th 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, Severn Trent paid out 77% of its profit as dividends. Paying out a majority of its earnings limits the amount that can be reinvested in the business. This may indicate a commitment to paying a dividend, or a dearth of investment opportunities.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Unfortunately, while Severn Trent pays a dividend, it also reported negative free cash flow last year. While there may be a good reason for this, it's not ideal from a dividend perspective.

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 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 is a measure of a company's total debt. Net interest cover measures the ability to meet interest payments. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. With net debt of 7.05 times its 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.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. With EBIT of 3.16 times its interest expense, Severn Trent's interest cover is starting to look a bit thin. Low interest cover and high debt can create problems right when the investor least needs them, and we're reluctant to rely on the dividend of companies with these traits.

Consider getting our latest analysis on Severn Trent'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 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£0.96 last year. This works out to be a compound annual growth rate (CAGR) of approximately 3.6% a year over that time.

While the consistency in the dividend payments is impressive, we think the relatively slow rate of growth is unappealing.

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. It's not great to see that Severn Trent's have fallen at approximately 8.7% over the past five years. A modest decline in earnings per share is not great to see, but it doesn't automatically make a dividend unsustainable. Still, we'd vastly prefer to see EPS growth when researching dividend stocks.

Conclusion

To summarise, shareholders should always check that Severn Trent's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. First, the company has a payout ratio that was within an average range for most dividend stocks, but it paid out virtually all of its generated cash flow. Second, earnings per share have actually shrunk, but at least the dividends have been relatively stable. In summary, Severn Trent 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.

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 11 analysts we track are forecasting for the future.

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