Is This Share’s 6.2% Dividend Yield Too Good to Be True?

There can be many shares out there that carry high dividend yields.

But, there are some with yields that are too good to be true – these are shares that would eventually result in a bad overall experience for investors because of subsequent poor business performances.

Keeping this in mind, what should investors make of Venture Corporation Ltd (SGX: V03)?

Venture Corp’s a provider of contract manufacturing services for electronics and medical equipment makers. At its current share price of S$8.08, the firm has a very attractive dividend yield of 6.2%, based on its dividend of S$0.50 per share for 2013 (Venture Corp’s last-completed financial year).

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

Picking safe yields

This is certainly not a comprehensive guide, but there are a few things I like to look at when it comes to finding safe yields:

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

The importance of this criterion lies in the insight it can give investors about management’s commitment to reward shareholders 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 by a company with the cash it has. That cash can come from a few sources: Debt; the issuing of new shares; and/or the company’s daily business operations.

Although there are always exceptions, it’s generally more sustainable for a company to be paying its dividends using the cash generated from its businesses.

It thus follows that investors should be keeping a close watch on a company’s free cash flow as it is the cash flow from operations that’s left 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 company that has a weak balance sheet laden with debt finds its dividends at risk of being cut or removed completely – either due to pressure from creditors or a simple lack of cash – if there are even just slight hiccups in the business.

Having a strong balance sheet that is flush with cash puts a company in good stead to tide over tough times and emerge unscathed.

Placing it all into context

The chart below shows how Venture Corp has fared against the three criteria:

Venture Corp's historical financials

Source: S&P Capital IQ

Between 2004 and 2013, Venture Corp has been paying remarkably consistent annual dividends which fluctuate between S$0.50 and S$0.58 per share. The contract manufacturer’s balance sheet has also been strong for the most part, as 2006 was the only year where it had more debt than cash.

Venture Corp’s free cash flow though, is where some cracks start to appear. Although the company has been able to consistently produce positive free cash flow, there have still been wild swings in the figure; there were also times when Venture Corp’s annual dividend had come in higher than the free cash flow produced (2004 and 2010 and are good examples).

These suggest that there may be some cyclicality to Venture Corp’s business that investors should take note of.

A Fool’s take

There are things to like about Venture Corp’s historical financials: The firm has been paying a consistent dividend (though it’d be even better if the dividend had been growing); it has a strong balance sheet; and it has been able to generate free cash flow most of the time.

Given these, the chances are low that Venture Corp’s attractive yield is too good to be true.

But that said, there are certainly still risks to consider. One’s Venture Corp’s shrinking revenue. In 2004, the contract manufacturer raked in S$3.19 billion in sales; over the 12 months ended 30 September 2014, revenue had declined to S$2.41 billion.

The lack of top-line growth may be an impediment to the company’s future ability to grow or produce free cash flow.

In any case, looking at Venture Corp’s historical financials alone is certainly not a holistic overview of the entire picture. Investors would still have to dig deeper and understand the qualitative aspects of Venture Corp’s business in order to have a better idea of whether brighter days are ahead.

Although a study of Venture Corp’s history can be informative, investors should never invest purely by peering into the rearview mirror.

For important updates about the stock market and more analyses about dividend investing, sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.

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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.