Would This Share With A 12.8% Dividend Yield Be A Great Dividend Stock?

A mistake that happens often with investors when they’re investing for income is to place too much focus on a share’s yield.

That can be a mistake because a share’s dividend yield tells us nothing about what’s important here: The safety and reliability of the company’s dividend.

Keeping these in mind, what should investors make of Design Studio Group Ltd (SGX: D11)?

Based on its current share price of S$0.51 and its dividend of 6.5 Singapore cents for 2014, the manufacturer, distributor, and installer of customized furniture products has a very appealing yield of 12.8%.

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

The makings of a safe yield

When it comes to finding safe dividends, there are a few things I like to find out:

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 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.

Although there’re 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 weak balance sheet that’s laden with debt puts a company’s dividends at risk of being reduced or removed – either due to pressure from creditors or from a simple lack of cash – even at the slightest hiccup in the fortunes of the firm’s business.

On the flip side, a strong balance sheet that’s flush with cash gives a company the ability to tide over tough times and emerge relatively unscathed.

Putting it all together

The chart below shows how Design Studio has fared against the three criteria for the decade stretching from 2004 to 2014:

Design Studio's historical financials

Source: S&P Capital IQ

Since initiating a dividend in 2007, Design Studio has been consistently sharing the spoils with its shareholders. In addition, the company’s dividends have also shown an unmistakable upward climb over the years.

Design Studio started the decade under study with a weak balance sheet that had more debt than cash but has gradually strengthened it over the years. It’s also worth pointing out that the company has had zero borrowings since 2009.

It’s not all a bed of roses for Design Studio however. The firm’s free cash flow did grow by a large margin from 2004 to 2014, but the important financial metric has been erratic throughout the decade and has come in lower than the dividends paid at times.

A Fool’s take

There’re clearly things to like about Design Studio’s finances, such as its strong balance sheet and consistent dividend. Coupled with its high-yield, it may just be a strong dividend share.

But that said, looking at Design Studio’s historical financials alone is certainly not a holistic overview of the entire picture. Investors should also take into account the qualitative aspects of Design Studio’s business and consider if brighter days are truly ahead for the firm.

In addition, there are still important risks to consider with the change in leadership being a particularly pertinent one; the firm’s long-time chief executive, Lim Leng Foo, had recently announced his decision to step down from his post.

A study of Design Studio’s history can be informative, but investors should never invest purely be 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.