Is This Share With A High Dividend Yield Of 7.4% Actually A Yield Trap?

I don’t think I’m too far off the mark to say that everyone loves a high dividend yield. But, it’s important to understand that we should never invest based on a share’s dividend yield alone.

That’s because a share’s yield tells us nothing about how safe or reliable its dividend is – and these are the important things you should be thinking about.

High yielding shares can easily turn out to be yield traps if their business performances subsequently become terrible, leading to a bad overall experience for shareholders.

With these in mind, what should investors make of electronic components distributor, Serial System Ltd (SGX: S69)?

At its current price of S$0.142, the company has a high dividend yield of 7.4% based on its annual dividend of 0.793 U.S. cents (roughly 1.05 Singapore cents) for its fiscal year ended 2014.

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

Hallmarks of a strong dividend share

The following’s by no means a comprehensive guide, but they are traits I like to look at when it comes to finding reliable dividends:

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

This is important for 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 with the cash a company has and that cash can come from a few sources: Debt; the issuing of new shares; the sale of assets; and/or the company’s daily business operations.

There are always exceptions, but it’s generally more sustainable for a company to pay its dividends using the cash it has 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 at their current state.

3. The strength of the company’s balance sheet

Having 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.

On the flipside, the possession of a strong balance sheet that is flush with cash puts a company in good stead to tide over tough times and emerge unscathed.

Pulling everything together

Here’s a chart showing how Serial System stacks up against the three criteria:

Serial System's historical financials

Source: S&P Capital IQ

As you probably could already tell, Serial System has not fared well.

Over the 11 years ended 2014, the company has had a spotty track record with its fluctuating dividends (there was no dividend in 2005), though there’s some semblance of stability from 2008 onwards.

The firm has also not been able to produce free cash flow in a consistent manner, spending seven years over the 11 under study in negative territory; the sharp swings in free cash flow also suggest that Serial System’s business may be very cyclical or capital intensive in nature.

Meanwhile, the company’s balance sheet has been weak over the years judging from how debt has always been higher than cash. It’s also worth noting that Serial System’s balance sheet has been weakening steadily since 2008 with the growth in debt out-pacing that of cash.

A Fool’s take

Given what we’ve seen so far, it seems that there’s a chance of Serial Systems being a yield trap.

But that said, this look at Serial System’s financial history is certainly not a holistic overview of the entire picture. Investors would still need to scrutinise the qualitative aspects of the firm’s business and think about its future prospects in order to come up with a better conclusion on its investing merits (or lack thereof). A look back at history can be informative, but we should never invest purely by peering into the rearview mirror.

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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.