Can This Share’s High 6% Dividend Yield Be Sustained?

A high dividend yield that’s backed by strong business fundamentals would be a wonderful thing for investors. Conversely, it won’t be a sustainable situation if a share’s high dividend yield is built upon shaky finances.

On that note, what should we make of Elec & Eltek International Company Ltd (SGX: E16)?

At its current share price of US$0.99, the printed circuit board manufacturer has a high dividend yield of 6.0% (based on its dividend of US$0.06 per share for 2014).

In contrast, 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.

The makings of a strong yield

When it comes to finding sustainable dividends, there are a few things I like to dig into:

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

This is important because it gives investors insight into management’s commitment to reward investors as the business grows.

  1. 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 issuance 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 an eye on a company’s free cash flow as it’s 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.

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

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

In contrast, a strong balance sheet that is flush with cash gives a company a valuable buffer against tough times.

Pulling the pieces together

Here’s a chart which shows how Elec & Eltek has fared against the three criteria from 2006 to 2014:

Elec & Eltek's historical financials

Source: S&P Capital IQ

For the period under study, Elec & Eltek had managed to pay a dividend and generate free cash flow consistently in each calendar year. But, both financial figures had shown no signs of stable growth at all.

In fact, the company’s dividends had been decreasing in each consecutive year since 2010 with its free cash flow displaying a similar trend.

The firm’s balance sheet had also remained weak the whole time with its borrowings exceeding cash.

A Fool’s take

Given Elec & Eltek’s track record thus far – its debt-laden balance sheet and inability to grow its dividends and free cash flow – it would seem that there’s a chance that the firm’s current level of dividends may not be sustainable.

That being said, it should be noted that this look at Elec & Eltek’s historical financials is certainly not a holistic overview of the entire picture. Investors would still have to dig into the qualitative aspects of the company’s business in order to have a better grasp of its future prospects.

An understanding of Elec & Eltek’s financial history can be important and informative, but investors should never invest purely be peering into the rearview mirror.

For more analyses on dividend investing and important updates about the stock market, sign up to 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.