Investors looking for passive investment income generally rely on dividend-paying stocks. However, it's important for investors not to equate a high dividend yield with a good investment. Dividend traps are companies with high dividend yields but generally underwhelming financials and business fundamentals. As an investor, you want to make sure the companies you're investing in can sustain their dividends for the long term.
Here are three metrics you can use to help you avoid falling into a dividend trap.
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1. Price-to-earnings ratio
Looking at a company's price-to-earnings (P/E) ratio is a great way to determine whether the company is overvalued or undervalued. To find a company's P/E ratio, you must first know its earnings per share (EPS), which can be calculated by dividing its profits by the number of its outstanding shares. Once you have the EPS, divide the company's stock price by that figure to find the P/E ratio. The higher the P/E ratio, the more expensive a stock is relative to its earnings.
While a low-priced stock that pays out dividends may seem attractive on the outside, it could also lead investors into a dividend trap. You shouldn't use a stock's price by itself to determine if it's overvalued or undervalued; a $5 stock could be overvalued, and a $500 stock could be undervalued. By looking at a company's P/E ratio and comparing it to similar companies in its industry, investors are better positioned to determine if a company is a good value, regardless of dividend yield.
2. Free cash flow
Though similar to profit, free cash flow measures how much money is coming into a business versus going out. If a company has more going out than coming in, it's considered cash flow negative. If it has more money coming in than going out, it's considered cash flow positive. Free cash flow is money companies can use to pay out dividends, repay creditors, make acquisitions, and buy back shares.
A company generating more free cash flow than it's paying out in dividend payments is good for investors. On the other hand, if a company is paying out more in dividends than it's generating in free cash flow, that's a red flag. Not only can the lack of free cash flow be concerning for the present, but it also calls into question a company's ability to continue paying (or increasing) its dividend in the future.
3. Debt-to-equity ratio
Debt-to-equity measures how much of a company's operations are funded by debt versus shareholder equity. You can find it by dividing its total liabilities by total shareholder equity. A low debt-to-equity ratio means a company's operations are funded more through equity vs. debt. A high debt-to-equity ratio means a company is getting more of its financing through debt, which is considered riskier.
While a high dividend yield is intriguing, investors should know how the company is managing to pay out the dividend it does. If a company is taking on loads of debt to keep its dividend payouts going, that should be considered a red flag. In corporate structures, companies have a higher obligation to pay back debts than to pay out dividends. So, if a company finds itself in financial trouble or headed toward bankruptcy, it's likely investors will see their dividends cut completely.
Don't take dividend payouts at face value
More than anything, it's important that you don't invest in a company solely based on its dividend payout because it could be masking some underlying financial problems the company is experiencing. If you're an investor who likes to focus on dividend-paying companies, ensure the company is producing sufficient cash and not loaded down with debt. That's one of the better ways to know whether the dividend is sustainable long term.
