This Share Illustrates the Danger of a Common Mistake Dividend Investors Commit

Many investors, when investing for income, often like to focus on a share’s dividend yield.

A common way of calculating the yield is to take a share’s dividend from its last-completed fiscal year and divide it by its current price. Now, this practice is useful in giving investors a good gauge for the dividend income they may receive from a share if the share’s dividend in the future remains unchanged compared to the past.

But, therein lies the danger for investors – the yield figure tells us nothing about how stable a share’s dividend is.

A share that has a very attractive yield can easily turn out to be a dud if its business fundamentals are weak and investors who make the mistake of placing undue emphasis on only the share’s yield would end up paying the price.

A concrete lesson

Investors in XMH Holdings Ltd (SGX: M9F) got a tough lesson on the subject yesterday. The engine and propulsion systems provider opened trading on Monday at a price of S$0.195. Based on its total dividend of S$0.012 per share for its fiscal year ended 30 April 2014 (FY2014), XMH’s shares had an impressive historical yield of 6.2%.

For some perspective on how attractive XMH’s yield is, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund tracking Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a yield of just 2.8% at the moment.

But with the release of XMH’s earnings results for the fourth-quarter of FY2015 on Monday evening, investors who had bought shares of the company at S$0.195 earlier that day would see their dividend yield shrink to just 4.1%. That’s because XMH had declared a final (and only) dividend of S$0.008 per share for FY2015, down 33% from a year ago.

The lessons therein

XMH was listed in January 2011 and from FY2011 to FY2014, the share had paid steady dividends. But, as you can see in the chart below, the company had a spotty track record with generating free cashflow.

The free cashflow metric is an important one to track for investors because it tells us the ability of a company to produce cash which can be used to pay dividends or grow and strengthen the business; without the ability to generate much free cashflow, a company would run the risk of having to cut its dividends someday.

XMH's total dividends and free cash flow (FCF) per share

Source: S&P Capital IQ

Meanwhile, the firm’s balance sheet, while remaining strong with cash exceeding borrowings, had seen its balance sheet steadily weaken (as alluded to by the declining cash and growing borrowings) for the same period as above.

XMH's balance sheet figures

Source: S&P Capital IQ

These signs, while certainly not perfect indicators that XMH’s dividend for FY2015 was bound to get slashed, were yellow flags which suggested that investors would want to cast a wary eye over XMH’s ability to maintain its dividends.

A Fool’s take

XMH ended FY2015 with negative free cashflow of S$13 million, a weak balance sheet (with S$24.6 million in cash but S$32.6 million in borrowings), and revenue that dropped by 13% to S$91.5 million. These are worse conditions than where XMH found itself in at the end of FY2014.

Investors who are attracted to XMH’s historical dividend yield of 4.1% (based on its current share price and annual dividend of S$0.008 per share for FY2015) at the moment, may want to carefully assess the firm’s ability to maintain or grow its dividend.

If you like what you've seen and would like more analyses on dividend investing and important updates about Singapore's stock market, sign up for The Motley Fool Singapore'sfree 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 companies mentioned.