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Is This Share With A 7.3% Dividend Yield Simply A Yield Trap?

A yield trap’s a share that has an enticing dividend yield but poor subsequent business performance such that investors would end up with a bad overall experience.

Keeping in mind that there can be many yield traps out there in the market, what should investors make of Valuetronics Holdings Limited (SGX: BN2)?

The electronics manufacturing services provider has a very attractive dividend yield of 7.3% based on its current share price of S$0.445 and its annual dividend of HK$0.20 per share (around 3.245 Singapore cents) for the financial year ended 31 March 2014 (FY2014).

In contrast, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which tracks the fundamentals of the market barometer the Straits Times Index (SGX: ^STI) – has a yield of just 2.7% at the moment.

The makings of a strong dividend share

There are a few things I like to look at when I’m on the hunt for reliable and safe dividends:

1. A company’s track record in growing and paying its dividend.

This criterion’s importance lies in the insight it can give investors about management’s commitment to reward investors as the business grows.

2. A company’s ability to grow its free cash flow over time and generate it in excess of the dividends paid.

Dividends are ultimately paid with the cash a company has and that cash can come from a few sources: Debt; the issuing of new shares; and/or the company’s daily business operations.

There are always exceptions, but it’s generally more sustainable if a company can pay its dividends using the cash generated from its businesses.

It thus follows that investors should be keeping an eye on a company’s free cash flow as it’s the cash flow from operations that’s left over after the firm has spent the necessary capital needed to maintain its businesses in their current state.

3. The strength of the company’s balance sheet.

A weak balance sheet that’s laden with debt puts a company’s dividend at risk from being cut or removed – either due to pressure from creditors or the simple lack of cash – if there are even any slight hiccups in the business.

Having a strong balance sheet that is flush with cash and with little debt gives a company valuable buffer against tough times.

Pulling it all together

The chart below shows how Valuetronics stacks up against the three criteria:

Valuetronics' historical financials

Source: S&P Capital IQ

Since its listing in 2007, Valuetronics has been paying a consistent dividend and has been able to generate free cash flow for the most part. But that said, there also seems to be some cyclicality in its business (judging from the swings in both its dividends and free cash flow) which investors might want to note.

Meanwhile, there should be no complaints whatsoever from investors on the balance sheet front for Valuetronics – the company’s balance sheet has been fortress-like with either minimal or zero borrowings since FY2007.

A Fool’s take

There are things to like about Valuetronics’ historical financials – specifically the steady upward march in its dividends and its rock solid balance sheet – so I think it’s fair to say that chances of it being a yield trap are low.

But, we should also note that even a long look at a firm’s history can’t provide us with a holistic overview of the entire picture. It’s crucial that we spend time understanding the qualitative aspects of Valuetronics’ business so that we can have a better grasp on the company’s future.

Valuetronics’ history – as important as it is – is definitely not a perfect indicator of how it’d fare going forward.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.