Like magic weight-loss pills or emails from a Nigerian prince notifying you of a fortune that awaits you, some things are too good to be true. High-yield stocks can fall within that category. However, not all big dividend payers belong in the recycle bin; the key to telling the difference is to spot these five signs of a yield trap early.
1. A really high yield
Identifying yield traps becomes much easier when you think about yield as a measure of value. The following chart shows how yield can change depending on what you're willing to pay for a company offering a $1 dividend.
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A company can raise or lower its dividend, but it's the market's manipulation of price -- that is, supply and demand -- that dictates yield. The higher the yield, the less investors are willing to pay for the stock. And while the stock market isn't perfect, there tends to be good reasons that stock prices fall.
Those reasons can be as benign as a weak quarter or as serious as a full-blown meltdown. But the more serious the problem, the greater the likelihood it's a yield trap.
One example is Citigroup during the financial crisis of 2008. Before the market collapsed, Citigroup's stock yielded 5%. As the economy went south, however, the New York-based bank's stock price plummeted, causing Citigroup's yield to climb up to 15% by December 2008. Citigroup later cut its dividend to a penny a share, as the company's stock price fell another 40% over the next few months. Citigroup was famously bailed out by the government, but investors that chased the stock's high yield in 2008 have yet to recoup their losses.
3. A high payout ratio
Citigroup is also a good example of a high payout ratio. In 2007, the company was paying out 50% of its net income. That's a sustainable figure under most circumstances, but that number jumped to 250% as Citigroup's earnings took a nosedive during the first quarter of 2008, and the company was forced to cut its dividend.
Again, this was a dramatic scenario, but it's not uncommon for a company's earnings to fall and its payout ratio to climb above 100% or more. And because paying out more than you earn is generally unsustainable, this situation almost always ends in dividend cuts.
However, there are exceptions to every rule. Plenty of rock-solid companies that can safely pay 80% or even 90% of their earnings toward dividends, and companies like REITs, BDCs, and even telecom will sport consistently skewed payout ratios because of high deprecation or other noncash charges. But a good red flag is when a company's payout recently spiked above their historical average.
4. Bad balance sheet
As with a high payout ratio, a subpar balance sheet is concerning. Dividends are at the bottom of a long line of obligations a company has to pay, and when push comes to shove, the dividend will be the first to go.
One metric for evaluating a companies stability is net debt to EBITDA. This subtracts cash and cash equivalents from total debt and then divides by a cash flow measure like EBITDA. The ratio paints a picture of how many years it would take for the company to pay back their debt if the situation remained constant. This is best used for comparing companies in the same industry, but, in general, a higher figure could be a warning signal.
Another option is to find a company's credit rating. Agencies like Standard & Poor's and Moody's use metrics like the one above and assign grades based on their judgement of a company's ability to repay debt. The scale is similar to what you remember from school. These agencies aren't always right, but a non-rated company or a grade below a B can be a good red flag.
5. Special dividends
Yield traps are normally underwhelming businesses -- but not always. The sneakiest kind of yield traps come about when companies get a little extra generous and throw off the formula.
Boston Properties is a great example. The company owns office towers in many major American cities, and this past December it sold a few of those large office buildings and rewarded shareholders with a special one-time dividend of $4.50 per share.
When you combine the special dividend with Boston Properties' regular dividend of $0.65 per quarter, you get $7.10 per share in dividends over the past 12 months. Divide that number by the company's current stock price of $120, and you get a yield of 6%. However, since you can't count on special dividends every year, the company's annual dividend will look more like $2.60 per share, which generates a yield of just over 2%. Getting caught in this trap may not kill you, but it will certainly make you feel silly.
The key to avoiding yield traps
As Mark Twain once said, "I'm more concerned about the return of my money than the return on my money." If you want to avoid getting caught in the deadly snare of yield traps, this is the best advice of all. Focus on finding great companies first, and looking for yield second, and you'll end up owning better businesses in a good position to pay you a consistent dividend.
Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.