Is This Share’s Dividend Yield Of 6.3% Too Good To Be True?

Shares with very attractive dividend yields are actually not that uncommon in Singapore’s stock market – you can see it for yourself with the free stock-screener that’s provided by stock exchange operator Singapore Exchange.

But, investors ought to be careful with high-yielding shares as there can be cases where the yields are simply too good to be true. Such shares are carrying high yields because the market may be expecting their businesses to deteriorate significantly in the future. And, if the dour expectation really does come to pass, the experience will not be good for investors, to say the least.

With these in mind, what should investors make of electronics manufacturer PCI Limited (SGX: P19)?

At its current price of S$0.475, the share has a yield of 6.3% thanks to its annual ordinary dividend of US$0.024 per share (around S$0.0299) for the financial year ended 30 June 2014 (FY2014).

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

Building blocks for a strong yield

There are generally a few factors I like to study when I’m trying to determine if a share’s yield is safe:

  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 actual 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’re two charts which show how PCI has fared against the three criteria over the past decade from FY2004 to FY2014:

PCI's dividends and free cash flow

PCI's balance sheet figures

Source: S&P Capital IQ

Let’s have a few words about what the charts are telling us.

First, here’re some of the bright spots:

  1. The electronics manufacturer has paid an annual dividend in each fiscal year since FY2004 and that’s a commendable achievement.
  2. PCI’s balance sheet is also rock-solid. Over the time frame under study, the firm has had zero borrowings and had also seen its cash hoard grow steadily.

Next, let’s walk through the worrying signs:

  1. Despite having distributed dividends without fail over the past 10 years, it’s worth highlighting that those pay-outs have fluctuated wildly. This indicates the possibility of a strong cyclicality in PCI’s business that investors might want to take note of.
  2. There hasn’t been any sustained growth in PCI’s free cash flow and that may place some doubts on the firm’s ability to grow its dividends in a conservative manner in the future.

A Fool’s take

There are certainly things to like about PCI’s financials (its clean balance sheet is one strong point), but given the spotty free cash flows and erratic amounts of dividends paid, there’s a chance that PCI’s current 6.3% yield may be too good to be true.

But that said, it’s important to note that this look at PCI’s historical financials is not a holistic overview of the entire picture. Investors should still dig into the qualitative aspects of the company’s business and consider its future prospects.

A study of PCI’s financial history can be important and informative, but more work needs to be beyond this 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.