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2 Signs a Business May Be in Trouble

By Motley Fool Staff - May 2, 2018 at 4:02PM

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If a stock’s dividend seems too good to be true, there might be trouble with the company.

Dividend yields are a function of a stock's price -- meaning that they increase as prices fall and decrease as prices rise. An exceedingly high dividend yield can be a result of a recent price drop, which could indicate trouble with the underlying business.

A full transcript follows the video.

This video was recorded on April 30, 2018.

Michael Douglass: That actually segues us very nicely -- and, I will admit, on my part, unintentionally -- into our fourth potential flag, which is little or negative cash flow.

Matt Frankel: Right. You don't want to see a company with negative cash flow after paying dividends, especially before paying dividends. All public companies issue three major financial statements -- the balance sheet, the income statement and the cash flow statement. The cash flow statement is readily available. So, you can see how a company is taking money in and paying money out. The dividend is one of the lines on the cash flow statement, so you can easily see how that factors into the equation. If a company's dividend exceeds its free cash flow, which is, as Michael said, the operating cash flow minus expenses, it could be a big red flag. That's the case in one of our examples coming up soon.

Douglass: Right. If a company is paying out cash, it should, generally speaking, be pulling in more cash than it's paying out. And, another piece to consider here is, think of this as a bit of a trade-off. Dividend stocks, generally speaking -- especially high-yielding dividend stocks, which is what we're really talking about as these potential yield traps -- tend not to be high-growth companies. If you're a high-growth company in a fast-growing part of the market, you should probably be, generally speaking, reinvesting your cash in R&D and expanding operations and marketing and things like that so that you can really grow that subscriber base or that customer base.

The dividend is usually there as kind of a, "Sorry we're not growing so much," sort of thing for income investors who are looking for something that doesn't have a ton of risk associated with it, and therefore, instead, they provide this predictable, hopefully, payout to investors. So, again, a company that's not generating a ton of cash and has a dividend, that raises some questions.

The fifth one -- it's funny, because we've talked about nuance with all of these, and they all come with nuance. The fifth one is the most nuanced of all, which is problems with the business.

Frankel: Yeah. Retail is a great example right now of a business that's having issues. If a business itself, if there's something wrong with it -- customer tastes are changing, people aren't buying your product anymore, your revenues have declined 50% over the past year, that's a big indication of a problem with the business. Dividends are a function of a stock's price. If a stock's price gets cut in half, its dividend yield will double. So, a lot of times, this is the reason you're seeing these excessive payouts.

A good thing I like to do, if I see a dividend that looks too good to be true, is look at a chart of the company's stock price over the past, say, two or three years, and see if there's a giant drop-off in price. That could be a really big indication that something is just wrong with the business itself.

Douglass: Right. Again, those five major criteria: unusually high dividend yield, excessive debt, high, seemingly unsustainable payout ratio, little or negative cash flow, and problems with the business.

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