Know This Before Buying Think Childcare Limited (ASX:TNK) For Its Dividend

Dividend paying stocks like Think Childcare Limited (ASX:TNK) 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. On the other hand, investors have been known to buy a stock because of its yield, and then lose money if the company's dividend doesn't live up to expectations.

With a goodly-sized dividend yield despite a relatively short payment history, investors might be wondering if Think Childcare is a new dividend aristocrat in the making. It sure looks interesting on these metrics - but there's always more to the story . 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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Payout ratios

Dividends are usually paid out of company earnings. If a company is paying more than it earns, 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, Think Childcare paid out 115% of its profit as dividends. 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. With a cash payout ratio of 128%, Think Childcare's dividend payments are poorly covered by cash flow. As Think Childcare's dividend was not well covered by either earnings or cash flow, we would be concerned that this dividend could be at risk over the long term.

Is Think Childcare's Balance Sheet Risky?

As Think Childcare's dividend was not well covered by earnings, we need to check its balance sheet for signs of financial distress. A quick check of its financial situation can be done with 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. Essentially we check that a) the company does not have too much debt, and b) that it can afford to pay the interest. Think Childcare has net debt of 1.28 times its EBITDA, which we think is not too troublesome.

Net interest cover can be calculated by dividing earnings before interest and tax (EBIT) by the company's net interest expense. Interest cover of 1.82 times its interest expense is starting to become a concern for Think Childcare, and be aware that lenders may place additional restrictions on the company as well.

Consider getting our latest analysis on Think Childcare's financial position here.

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. Looking at the data, we can see that Think Childcare has been paying a dividend for the past four years. It has only been paying dividends for a few short years, and the dividend has already been cut at least once. This is one income stream we're not ready to live on. During the past four-year period, the first annual payment was AU$0.072 in 2016, compared to AU$0.04 last year. This works out to a decline of approximately 44% over that time.

A shrinking dividend over a four-year period is not ideal, and we'd be concerned about investing in a dividend stock that lacks a solid record of growing dividends per share.

Dividend Growth Potential

With a relatively unstable dividend, and a poor history of shrinking dividends, it's even more important to see if EPS are growing. Strong earnings per share (EPS) growth might encourage our interest in the company despite fluctuating dividends, which is why it's great to see Think Childcare has grown its earnings per share at 30% per annum over the past five years. Earnings per share have been growing very rapidly, although the company is also paying out virtually all of its profit in dividends. While EPS could grow fast enough to make the dividend sustainable, in this type of situation, we'd want to pay extra attention to any fragilities in the company's balance sheet.

We'd also point out that Think Childcare issued a meaningful number of new shares in the past year. Regularly issuing new shares can be detrimental - it's hard to grow dividends per share when new shares are regularly being created.

Conclusion

To summarise, shareholders should always check that Think Childcare's dividends are affordable, that its dividend payments are relatively stable, and that it has decent prospects for growing its earnings and dividend. Think Childcare paid out almost all of its cash flow and profit as dividends, leaving little to reinvest in the business. Next, earnings growth has been good, but unfortunately the dividend has been cut at least once in the past. In summary, Think Childcare has a number of shortcomings that we'd find it hard to get past. Things could change, but we think there are likely more attractive alternatives out there.

Companies that are growing earnings tend to be the best dividend stocks over the long term. See what the 3 analysts we track are forecasting for Think Childcare for free with public analyst estimates for the company.

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.