Can This Stock With A 5% Yield Be A Good Dividend Investment?

Investors who are out looking for stocks with high dividend yields may have come across Challenger Technologies Limited (SGX: 573).

At its current share price of S$0.47, the information-technology (IT) products retailer has a tasty yield of 5% thanks to its annual dividend of S$0.0235 per share in 2014.

In contrast, 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’ 3.3% at the moment.

But, it’s worth noting that Challenger Technologies’ high yield alone does not make it a good dividend stock. What’s more important here is the company’s ability to maintain or grow its payouts in the future.

Makings of a strong dividend stock

When it comes to assessing that, there are a few things in general about a company that I like to dig into:

  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.

Dividends are ultimately paid using the cash that a company has and that can come 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. The higher the company’s free cash flow can be over time, the larger the potential for growing dividends.

  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 the resources to protect its dividends during the inevitable tough times that rolls along every now and then.

In addition, it enables the firm to go on the offensive during a downturn and reinvest for growth even as its financially weaker competitors have to batten down the hatches; this plants the seeds for potentially higher dividends in the future.

Challenger Technologies’ dividend: Yay or nay

Let’s look at the chart below to see how Challenger Technologies’ dividends and free cash flow has fared against the first two criteria:

Chart 1 - Challenger Technologies' total dividends and free cash flow (FCF) per share

Source: S&P Capital IQ

There are a couple of praise-worthy aspects about Challenger Technologies that are shown in Chart 1.

First, Challenger Technologies has not only managed to pay a dividend consistently over the decade from 2004 to 2014, it has also raised its payouts slightly over time too. Second, the company has, for the most part, generated growing free cash flow which has come in higher than the dividends paid.

In Chart 2 below, you can see how the company’s balance sheet has evolved from 2004 to 2014.

Chart 2 - Challenger Technologies' balance sheet figures

Source: S&P Capital IQ

Over the timeframe under study, Challenger Technologies has done an admirable job in keeping its balance sheet strong – not only has the amount of cash on hand grown over the years, the company has also had minimal or zero borrowings.

A Fool’s take

Given what we’ve seen with Challenger Technologies – its steady dividends, rising free cash flow, and debt-free balance sheet – it’d appear that the company has a large margin of safety in place when it comes to sustaining or raising its dividends in the years ahead.

That said, investors should note that this look at Challenger Technologies’ financial history is not a holistic overview of the entire picture. Investors would still need to study the qualitative aspects of the firm’s business and consider if brighter days are ahead.

One particularly important issue to think about would be the future of bricks-and-mortar retail of IT products in the face of a growing trend of e-commerce. Can Challenger Technologies’ traditional retail stores hold their ground in the face of a rise in online retail?

Only when that question and more are considered can an intelligent investing decision be reached.

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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.