Here's How We Evaluate Mercuries Data Systems Ltd.'s (TPE:2427) Dividend

Dividend paying stocks like Mercuries Data Systems Ltd. (TPE:2427) 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 popular dividend stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

With a six-year payment history and a 3.1% yield, many investors probably find Mercuries Data Systems intriguing. It sure looks interesting on these metrics - but there's always more to the story. Some simple analysis can reduce the risk of holding Mercuries Data Systems for its dividend, and we'll focus on the most important aspects below.

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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. In the last year, Mercuries Data Systems paid out 43% of its profit as dividends. A medium payout ratio strikes a good balance between paying dividends, and keeping enough back to invest in the business. One of the risks is that management reinvests the retained capital poorly instead of paying a higher dividend.

Another important check we do is to see if the free cash flow generated is sufficient to pay the dividend. Mercuries Data Systems paid out 203% of its free cash flow last year, suggesting the dividend is poorly covered by cash flow. Paying out such a high percentage of cash flow suggests that the dividend was funded from either cash at bank or by borrowing, neither of which is desirable over the long term. While Mercuries Data Systems' dividends were covered by the company's reported profits, free cash flow is somewhat more important, so it's not great to see that the company didn't generate enough cash to pay its dividend. Cash is king, as they say, and were Mercuries Data Systems to repeatedly pay dividends that aren't well covered by cashflow, we would consider this a warning sign.

Remember, you can always get a snapshot of Mercuries Data Systems' latest financial position, by checking our visualisation of its financial health.

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. Looking at the data, we can see that Mercuries Data Systems has been paying a dividend for the past six years. It's good to see that Mercuries Data Systems has been paying a dividend for a number of years. However, the dividend has been cut at least once in the past, and we're concerned that what has been cut once, could be cut again. During the past six-year period, the first annual payment was NT$0.3 in 2015, compared to NT$0.3 last year. This works out to be a compound annual growth rate (CAGR) of approximately 5.8% a year over that time. Mercuries Data Systems' dividend payments have fluctuated, so it hasn't grown 5.8% every year, but the CAGR is a useful rule of thumb for approximating the historical growth.

It's good to see the dividend growing at a decent rate, but the dividend has been cut at least once in the past. Mercuries Data Systems might have put its house in order since then, but we remain cautious.

Dividend Growth Potential

With a relatively unstable dividend, it's even more important to see if earnings per share (EPS) are growing. Why take the risk of a dividend getting cut, unless there's a good chance of bigger dividends in future? Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it's great to see Mercuries Data Systems has grown its earnings per share at 46% per annum over the past five years. With high earnings per share growth in recent times and a modest payout ratio, we think this is an attractive combination if earnings can be reinvested to generate further growth.

Conclusion

To summarise, shareholders should always check that Mercuries Data Systems' dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. Mercuries Data Systems has a low payout ratio, which we like, although it paid out virtually all of its generated cash. Next, earnings growth has been good, but unfortunately the dividend has been cut at least once in the past. While we're not hugely bearish on it, overall we think there are potentially better dividend stocks than Mercuries Data Systems out there.

Companies possessing a stable dividend policy will likely enjoy greater investor interest than those suffering from a more inconsistent approach. Meanwhile, despite the importance of dividend payments, they are not the only factors our readers should know when assessing a company. Case in point: We've spotted 3 warning signs for Mercuries Data Systems (of which 1 doesn't sit too well with us!) you should know about.

If you are a dividend investor, you might also want to look at our curated list of dividend stocks yielding above 3%.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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