Dividends can make investing in certain companies worthwhile. Many dividend-paying companies may not have the same hypergrowth potential as younger, smaller companies, but they can be a great source of reliable income, which can be especially attractive to those in retirement. If you're looking to become intentional with your dividend investing, you'll want to do your best to avoid dividend traps.
A dividend trap is a too-good-to-be-true dividend yield that's unsustainable. They're not always the easiest to spot, but doing these three things will definitely help.
1. Don't just look at the dividend yield
Although it's the most common metric cited for dividends, dividend yields can be misleading. When companies set their dividend, they generally do it as a dollar amount. If a company pays out $1 in annual dividends and its stock price is $20, its dividend yield is 5%. However, if the stock price drops to $10 for whatever reason, the dividend yield is now 10%.
If you didn't know any better, you could look at the increased dividend yield as a reason to invest, without considering why the stock price dropped. Don't let a higher dividend yield entice you into overlooking if the drop is due to something fundamentally weak about the company. If the company is faltering, that doesn't bode well for the dividend staying strong.
2. Pay attention to the payout ratio
The payout ratio lets you know how much of its earnings a company is paying out as dividends. You can calculate the dividend payout ratio by dividing a company's yearly dividend by its earnings per share (EPS). You can find these numbers when you're looking at a stock on your brokerage platform or from the reports a company files with the Securities and Exchange Commission.
If a company's payout ratio is more than 100%, it's paying out more in dividends than it's earning, which, as I'm sure you can guess, isn't a good thing. There isn't a dividend payout ratio that's universally considered "good" because dividend best practices can vary widely between industries, but in general, you probably want a ratio between roughly 30% and 50%.
If it's less than that, the company may not be as shareholder-friendly as you'd like, though there's more room to increase the dividend. If it's more than that, the dividend may not be sustainable, and it could mean the company isn't reinvesting enough money back into itself. A company's payout ratio can be influenced by many things, including its free cash flow, past dividend rates (companies aim to increase dividends with time), earnings stability, and other investment opportunities.
3. Know a company's debt levels
There's nothing wrong with a company having debt. In fact, sometimes, it makes sense for a company to take on debt because the return on investment will be higher than the interest it's paying. However, with debt comes risk, and at some point, too much becomes a red flag, particularly if the debt is being used to pay the dividend.
By looking at a company's debt-to-equity ratio -- which is found by dividing its total debt by shareholder equity -- you can get an idea of just how much of the business is run on debt. You can find this information on a company's balance sheet. Ideal debt-to-equity ratios vary widely by industry. Technology businesses tend to have lower ratios (2 or under), while other businesses, like those in manufacturing, tend to have a bit higher ratios. It's wise to be cautious of any ratio pushing the 5 to 6 mark, though.
Investing in dividend-paying stocks can be a great way to make money. If you keep the three tips above in mind, you'll increase your chances of avoiding dividend traps.