Q: There's a stock I have my eye on that pays a 10% dividend yield. This sounds too good to be true. Is it?
Generally speaking, double-digit dividend yields are indeed too good to be true. They are often either being paid by unstable companies, or simply represent too much of a company's earnings to be sustainable.
Of course, there are some exceptions. There are a few questions you should ask yourself to help you avoid dividend yield traps, which is a common term for stocks with too-good-to-be-true dividends. I'll use two stocks as examples to illustrate them.
For starters, does the stock pay an unusually high dividend for its industry? Most telecom stocks have yields around 5%, so CenturyLink's 11% yield should certainly set off alarm bells. However, senior housing REITs tend to pay 6% to 7% right now, so Senior Housing Property Trust's 8% yield isn't necessarily out of the ordinary.
Next, does the payout represent an excessive percentage of a company's net income? Senior Housing Property Trust pays out about 86% of its funds from operations -- a completely normal payout for a REIT. Meanwhile, CenturyLink pays out more than 135% of its trailing-12-month earnings, a potential red flag.
Finally, are there problems with the business from a long-term perspective? For example, some forms of brick-and-mortar retail are having trouble adapting to the e-commerce surge, so 10%-yielding DDR Corp, an owner of shopping centers, could have a tough time maintaining its payout. On the other hand, senior housing is a growing market, so Senior Housing Properties Trust doesn't have a similar long-term trend working against it.
To be clear, these are just a few examples of things to look for and aren't reasons to buy (or not buy) the stocks mentioned here. However, they can give you an idea if a stock's dividend could be in trouble.