Here’s Why This Share With A 12.8% Dividend Yield Could Be a Yield Trap

World Precision Machinery Limited (SGX: B49) may be on the radar of investors looking out for high yields.

At its current share price of S$0.335, the firm has a very high dividend yield of 12.8% based on its annual dividend of RMB0.20 per share (roughly 4.27 Singapore cents) for 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) – has a yield of just 2.7% at the moment.

A potential trap

But if we dig beneath the surface, there are reasons to suspect that World Precision Machinery, a manufacturer of stamping, cutting, and bending machines, may be a yield trap.

A yield trap’s a share which attracts investors with an appealing dividend yield, only to then become a disappointing investment as a result of its deteriorating business performance.

There are a few things I like to find out when I’m hunting for strong 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 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 can be 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 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 gives a company the ability to rough out difficult business or economic conditions and emerge unscathed.

Ticking off the boxes

We can see in the chart below, how World Precision Machinery has fared against the three criteria since its listing in 2006:

World Precision Machinery's historical financials

Source: S&P Capital IQ

As you can probably tell, World Precision Machinery hasn’t scored well against the three criteria.

The firm only started paying a dividend in 2009 and while it has managed to consistently pay a dividend since, those payouts have fluctuated wildly in value (from RMB0.135 per share in 2011 to just RMB0.05 per share in 2012, for instance).

World Precision Machinery has also had trouble generating consistent free cash flow and has generally had a weak balance sheet that has way more debt than cash.

A Fool’s take

Given what we’ve seen, it seems like the only attractive thing about World Precision Machinery as an income stock may be its high dividend yield.

But that said, investors should realise that this study of World Precision Machinery’s historical financials is not a holistic overview of the overall picture. A deeper look into the qualitative aspects of the firm’s business is needed to determine if brighter days may be ahead.

An analysis of World Precision Machinery’s financial history is important, but investors should never invest purely by looking 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.