Should you buy Service Stream (ASX:SSM) stock for its dividend payment?

Dividend payments must always be tested to make sure the company can actually afford to pay them. Cuts to these payments do happen, and share prices tend to react badly as a result.

Here are some quick calculations that, when combined together, go a long way in proving a company's ability to continue paying its shareholders. Let's take Service Stream (ASX:SSM), the provider of essential network services, including access, design, build, installation and maintenance across copper, fiber and wireless telecommunications networks, as an example. The company pays a rolling dividend yield of 3.07%.

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Checking up on Service Stream (ASX:SSM)’s dividend cover

Dividend cover is perhaps the most widely used measure of dividend health and is simply a company’s earnings per share divided by its dividend per share (EPS/DPS). Generally speaking, dividend cover of less than 1.5x earnings requires further investigation.

• The rolling dividend cover is based on projected dividends and earnings. Service Stream’s rolling dividend cover is 1.92.
• The historic dividend cover is, of course, based on historic dividends and earnings.

  Service Stream’s trailing twelve month dividend cover is 1.55.

Both of these figures are above the 1.5x safety threshold for Service Stream. This suggests that the dividend could be safe.

Measuring balance sheet strength

An alternative way to analyse dividend safety is to focus more directly on a company’s balance sheet strength. A highly leveraged company that struggles to meet its short-term liabilities is more likely to cut its dividend than a well-financed one.

A safe level of gearing (debt to equity) on the balance sheet is generally considered to be 50 percent or less. Service Stream’s gearing ratio is -31.7% - below the 50% threshold.

The current ratio (current assets / current liabilities ) assesses a company’s ability to service short term debts. A current ratio of less than one tends to be a worry. Service Stream’s current ratio is 1.64 - above the 1x threshold.

Assessing  fundamental momentum

A useful measure used by SocGen to assess dividend safety is an indicator known as the F-Score, which  looks more deeply into the direction in which a company's financial state is moving. Companies are likely to have a safer dividend if the financial state is improving. Service Stream’s F-Score is 9. This suggests that Service Stream’s dividend is safe.

Gauging cash generation

We can assess how well Service Stream can cover its cash payments by comparing Free Cashflows Per Share (FCF PS) with the Dividend Per Share (DPS). Service Stream generated 13c in FCF PS. This is higher than the dividend payout 8c and indicates that the company has generated enough FCF to cover dividends. It looks like the company's rolling 3.07% yield is safe according to all of these preliminary checks.

Systematic investing: the factor is your friend

For many investors, dividends are a vital part of their long-term strategy. That's why we have created a variety of income-focused stock screens, such as the Best Dividends Screen, to identify promising candidates for income portfolios. Take a look and see if any of the qualifying stocks might be worthy of further research.

One of the most useful benefits of a strong track record of sustainable, rising dividend payments is often a reduction in share price volatility. This area is at the forefront of academic investment research and papers continue to be published on how to tap into what is referred to as the low-volatility anomaly. That's why we have created our own RiskRatings, which categorise stocks according to their volatility and offer you another way to think about your investments.