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Is This Share With A 14.1% Dividend Yield A Yield Trap?

Shares with high dividend yields can make for very attractive investing targets. But, it’s important to note that such a share could easily be a yield trap, a share with a high yield that ends up being a disappointing investment as a result of a deteriorating business.

For this reason, investors should never invest in a share just because it has a high yield as the yield figure tells us nothing about what’s really important here: The safety and reliability of the share’s dividend.

With these in mind, what should investors make of Shanghai Turbo Enterprises Ltd (SGX: AWM)?

At its current price of S$0.76, the vane products manufacturer has a really attractive dividend yield of 14.1% thanks to its annual dividend of RMB0.50 per share (around S$0.107 per share) in 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 anatomy of a safe dividend

There are a few things I like to dig into when I’m trying to determine how safe a company’s future dividends are:

  1. The 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.

  1. The company’s ability to grow its free cash flow over time and generate it in excess of the dividends paid.

Ultimately, a company pays its dividends with 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 its assets, and/or 4) generate cash from its daily business activities.

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 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.

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

When a company has a weak balance sheet that’s laden with debt, its dividends can be 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 its business.

On the other hand, a strong balance sheet that is flush with cash gives a company an ability to tide over the inevitable tough times that rolls along every now and then.

Pulling it all together

Here are two charts which show how Shanghai Turbo Enterprises has fared against the three criteria from 2009 to 2014 (the company had paid its first dividend back in 2009):

Shanghai Turbo Enterprises' dividends and free cash flow

Shanghai Turbo Enterprises' balance sheet figures

Source: S&P Capital IQ

Let’s have a few words about the company’s track record.

The first chart shows that Shanghai Turbo Enterprises has had a spotty history when it comes to paying a dividend; there was no pay-out in 2013. In addition, the firm has also had issues with generating consistent free cash flow.

On the other hand, the company’s balance sheet has been really strong – there had been zero borrowings for the years under study and that’s certainly commendable.

A Fool’s take

Shanghai Turbo Enterprises’ clean balance sheet is something to like. But, there are other important areas of concern, such as the firm’s inability to produce free cash flow and pay out dividends in a consistent manner. It thus follows that there’s a chance the firm may be a yield trap.

But that being said, it should be noted that this look at Shanghai Turbo Enterprises’ historical financials is not a holistic overview of the entire picture. Investors would still need to dig into the qualitative aspects of the firm’s business and consider its future prospects.

A study of Shanghai Turbo Enterprises’ history can be important and informative, but more work needs to be done beyond that before any investing decision can be made.

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.