Should You Buy McMillan Shakespeare Limited (ASX:MMS) For Its 5.8% Dividend?

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Today we'll take a closer look at McMillan Shakespeare Limited (ASX:MMS) 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. 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, McMillan Shakespeare likely looks attractive to investors, given its 5.8% dividend yield and a payment history of over ten years. We'd guess that plenty of investors have purchased it for the income. Some simple analysis can reduce the risk of holding McMillan Shakespeare for its dividend, and we'll focus on the most important aspects below.

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

Payout ratios

Dividends are typically paid from company earnings. If a company pays more in dividends than it earned, then the dividend might become unsustainable - hardly an ideal situation. Comparing dividend payments to a company's net profit after tax is a simple way of reality-checking whether a dividend is sustainable. McMillan Shakespeare paid out 123% of its profit as dividends, over the trailing twelve month period. Unless there are extenuating circumstances, from the perspective of an investor who hopes to own the company for many years, a payout ratio of above 100% is definitely a concern.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. McMillan Shakespeare paid out 51% 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. 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.

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 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. McMillan Shakespeare has net debt of 1.20 times its earnings before interest, tax, depreciation and amortisation (EBITDA), which is generally seen as an acceptable level of debt.

We calculated its interest cover by measuring its earnings before interest and tax (EBIT), and dividing this 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.

Remember, you can always get a snapshot of McMillan Shakespeare'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 McMillan Shakespeare's dividend payments. The dividend has been cut by more than 20% on at least one occasion historically. During the past ten-year period, the first annual payment was AU$0.19 in 2009, compared to AU$0.74 last year. Dividends per share have grown at approximately 15% per year over this time. McMillan Shakespeare's dividend payments have fluctuated, so it hasn't grown 15% every year, but the CAGR is a useful rule of thumb for approximating the historical growth.

So, its dividends have grown at a rapid rate over this time, but payments have been cut in the past. The stock may still be worth considering as part of a diversified dividend portfolio.

Dividend Growth Potential

With a relatively unstable dividend, it's even more important to evaluate if earnings per share (EPS) are growing - it's not worth taking the risk on a dividend getting cut, unless you might be rewarded with larger dividends in future. Over the past five years, it looks as though McMillan Shakespeare's EPS have declined at around 6.3% a year. 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

To summarise, shareholders should always check that McMillan Shakespeare'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 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 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 this analysis, McMillan Shakespeare doesn't shape up too well as a dividend stock. We'd find it hard to look past the flaws, and would not be inclined to think of it as a reliable dividend payer.

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 6 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.