Would This Share With A Tasty Yield Of 5.4% Be A Great Dividend Play?

A high-yielding share can seem like an attractive investment. But, investors should never invest based on share’s yield alone as the yield figure tells us nothing about what’s important here – the safety and reliability of the share’s dividend.

Keeping this in mind, what should we make of specialized steel products maker Hupsteel Limited (SGX: H73)?

Based on its current share price of S$0.186, Hupsteel has a tasty dividend yield of 5.4% thanks to its annual dividend of S$0.01 per share in FY2014 (financial year ended 30 June 2014).

In comparison, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which aims to mimic the fundamentals of Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a yield of just 2.65% at the moment.

What makes for a solid dividend

Safe and reliable dividends can only come about if a company possesses strong business fundamentals. And to separate the wheat from the chaff when it comes to that, there are a few things I like to dig into:

  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.

  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 by a company using the cash it has and that cash can from a few sources. A company can 1) take on debt, 2) issue new shares, 3) sell off assets, and/or 4) generate cash from its 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.

  1. 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 relatively unscathed.

Pulling it all together

Here are two charts which show how Hupsteel has fared against the three criteria over time:

Hupsteel's dividends and free cash flowHupsteel's balance sheet figures

Sources: S&P Capital IQ

There are a number of things to like about Hupsteel’s finances. Besides having a strong balance sheet that has had more cash than debt since FY2009, the firm has also been paying an annual dividend consistently since at least FY2005. That’s 10 years – and counting – of dividends from Hupsteel.

But, there are also some important areas of concern. The firm has not been able to grow both its dividends and free cash flow; in fact, those dividends have steadily decreased over time. In addition, the free cash flow metric, as you can see in the first chart, has also been erratic, coming in near or below zero for a good number of years in the period under study.

A Fool’s take

Although Hupsteel does deserve a thumbs up for its solid balance sheet and track record in paying a dividend, there are more important negative factors – shrinking dividends and volatile free cash flow – to consider too.

By pulling all these different factors together, there’s thus a chance that the firm may not be a great dividend play.

That being said, it’s important to note that this look at Hupsteel’s historical financials isn’t a holistic overview of the overall picture. We’d still have to dig deeper into the qualitative aspects of the company’s business and consider if brighter days are ahead.

A study of Hupsteel’s financial history can be important and informative. But more work definitely needs to be done beyond that before any investing decision can be reached.

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.