Would This Stock With A 12% Yield Be A Great Dividend Investment?

Precision engineering outfit UMS Holdings Limited (SGX: 558) may have caught the eyes of investors looking for a growing stream of dividend income.

As you can tell from the chart below, the company, which manufactures high precision semiconductor components and provides testing services as well as complex electromechanical assembly, has seen its dividends grow steadily over the past few years from S$0.04 per share in 2010 to S$0.06 in 2014:

Chart 1 - UMS's total dividends (ordinary and special) per share

Source: S&P Capital IQ

At its current share price of S$0.50, UMS also carries a very attractive dividend yield of 12% thanks to its aforementioned payout in 2014. For some perspective, the SPDR STI ETF (SGX: ES3) – an exchange-traded fund which tracks the fundamentals of Singapore’s market barometer, the Straits Times Index (SGX: ^STI) – has a yield of only 3.3% at the momet.

UMS’s high-yield and history of rising dividends may have possibly made it a very attractive investment target for dividend investors. But, there’s an important risk to note with the company’s dividend. The chart below illustrates UMS’s payout ratios over the same period as Chart 1 above:

Chart 2 - UMS's payout ratios

Source: S&P Capital IQ

Payout ratios (dividends as a percentage of earnings and dividends as a percentage of free cash flow) give investors an indication of how much headroom a company has to deal with future hiccups to its business and still protect or even grow its dividends. In general, the lower the ratios, the better.

In UMS’s case, Chart 2 makes it clear that the payout ratios have been climbing. In 2010, UMS’s dividend was 60.6% and 73% of profit and free cash flow, respectively. By 2014, the numbers had risen to 103% and 89%. The high payout ratios currently sported by UMS points to a thin margin of safety when it comes to its ability to maintain its dividend.

There are still strong positives with UMS here. In UMS’s recent earnings release for the first-half of 2015, the company’s free cash flow had grown by 34% to S$19 million. Moreover, the firm’s balance sheet is rock-solid; as of 30 June 2015, there was S$39.6 million in cash and zero borrowings. The balance sheet in particular can provide some cushion for UMS to tide over any temporary troubles.

In sum, while UMS has many good things going for it (for instance, its high yield, track record of raising its dividend, strong balance sheet, and solid growth in its recent results), its room for error is not particularly wide when it comes to its ability to protect or grow its dividends in the future. That’s a risk investors have to note. A careful appraisal of the risks and rewards by investors is needed before any investing conclusion can 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.