With A 10.9% Dividend Yield, Is This Share A Great Dividend Play?

High-yielding shares can be very attractive investments. But at the same time, they could also be yield traps, shares with high yields that end up being disappointing investments because of their poor subsequent business performances.

It is for this reason that investors should never invest based on a share’s dividend yield alone as the yield tells us nothing about what’s important – the safety and reliability of the company’s dividend.

With that, what should investors make of UMS Holdings Limited (SGX: 558)?

UMS is a precision engineering outfit which manufactures amongst other things, high precision semiconductor components. At its current price of S$0.53, the firm has a very attractive dividend yield of 10.9% based on its annual dividend of 5.8 Singapore cents per share for the fiscal year ended 2014.

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

The anatomy of a reliable dividend

Although the following’s certainly not a comprehensive guide, they are actually some of the things I like to look at when I’m on the hunt for reliable dividends:

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 ultimate paid by a company using the cash it has. This cash can from a few sources: Debt; the issuing of new shares; the sale of assets; and/or the company’s daily business activities.

Although there are always exceptions, 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 an eye on a company’s free cash flow as it’s the cash flow from the firm’s business operations that’s left after it has spent the necessary capital needed to maintain its businesses at their current state.

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

A company that has a weak balance sheet that’s bloated with debt finds its dividends at risk of being cut or removed completely – either due to pressure from creditors or from a simple lack of cash – if there are even just slight hiccups in its business.

On the other hand, a strong balance sheet (one that is flush with cash and with little or no debt) puts a company in good stead to tide over tough times and emerge unscathed.

Putting the puzzle together

Here’s a chart showing how UMS has fared against the three criteria over the 10 year period from 2004 to 2014:

UMS Holdings' historical financials

Source: S&P Capital IQ

UMS has managed to consistently pay a dividend, and has even managed to steadily increase its payout over the years. The company’s balance sheet has also remained strong for the most part, with just one year in the decade under study (2004) where cash came in lower than debt.

But that said, there are clues which point to the firm’s business being cyclical in nature. For instance, the firm’s dividends actually fell sharply from 1.88 cents in 2006 to 0.04 cents in 2008; UMS’s track record with producing free cash flow has also been spotty with wild swings in that particular financial figure. This is something investors may want to note.

A Fool’s take

There are certainly things to like about UMS’s financials, such as its growing dividend and strong balance sheet. But, there are certainly risks to consider with two in particular being the firm’s cyclical business and lack of revenue growth:

1. Just like how its free cash flow has swung wildly, UMS’s revenue has also experienced volatile ups-and-downs; from a perch at S$167.5 million in 2006, the company’s revenue actually dipped to S$47.3 million in 2009.

2. As for the lack of top-line growth, it is apparent when we look at UMS’s 2014 revenue of S$110 million – that’s a figure which is one-third lower than in 2006.

Thus on balance, despite its high yield and the possession of certain desirable financial characteristics, the cyclical nature of UMS’s business may not make it an attractive dividend share for the long-term.

But that said, it’s worth pointing out that a look at UMS’s historical financials can’t give us a holistic overview of the entire picture. We’d still have to take a deeper look at the qualitative aspects of its business in order to arrive at a better conclusion on its investing merits.

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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.