A dividend trap is a high-yield dividend stock whose payout is simply too good to be true or to be sustainable. Often, dividend traps have high debt loads, unsustainable payout ratios, and other red-flag metrics. Many times, the reason for the high yield is a massive drop in the stock price due to trouble in the business.

Ways to spot a dividend trap

The most obvious way to spot a dividend trap is by a dividend yield that looks too good to be true -- specifically, a dividend yield that doesn't make sense within a certain industry.

Businessman being pulled into a black hole of money.

Image source: Getty Images.

For example, real estate investment trusts, or REITs, typically pay dividends in the 4%-7% range. So, a REIT with a 6.5% dividend wouldn't necessarily be a red flag. On the other hand, bank stocks pay an average dividend yield of just 1.4% as of this writing, so a bank stock with a 6.5% yield might be a sign of a dividend trap.

To be clear, this isn't a foolproof way of spotting dividend traps. However, it's certainly an indication that you should take a closer look into the fundamentals of the stock before investing.

Here are a couple of things that generally mean you should stay away.

  • Lots of debt -- Stocks that carry too much debt are more prone to cutting their dividends during tough times. A good metric to look at is the stock's debt-to-equity ratio. Generally speaking, an ideal debt-to-equity ratio will be below 1, but slightly higher is often OK. Debt-to-equity ratios tend to vary considerably between different industries, so this is most effective when used to compare a stock to others in the same industry.
  • Dividends exceed earnings -- A payout ratio is a stock's dividend expressed as a percentage of its earnings. For example, if a stock earns $5.00 per share and pays a $2.00 dividend, its payout ratio is 40%. I like to see payout ratios of 50% or less, with the exception of REITs which are required to pay out most of their earnings. In any case, a payout ratio in excess of 100% means that a company is paying out more than it earns, which is generally unsustainable.

A potential dividend trap versus a solid dividend stock

To illustrate this concept, let's take a look at two telecommunications stocks: CenturyLink (NYSE:CTL) and AT&T (NYSE:T). Now, this isn't exactly an apples-to-apples comparison, but the general business fundamentals should be similar.

Just looking at the dividend yield, CenturyLink's 12.2% dividend yield is more than twice AT&T's 5.3%. An income investor, at first glance, may be more inclined to go with the former. However, pay attention to some of the key metrics:

Metric

CenturyLink

AT&T

Annual dividend

$2.16

$2.00

Dividend yield (Jan. 26, 2018)

12.2%

5.3%

Debt-to-equity ratio

1.93

1.31

Projected 2018 earnings

$1.23

$3.02

Payout ratio (forward)

176%

66%

Data source: TD Ameritrade (dividends, yield, projected earnings), company financials (debt to equity). Debt-to-equity ratio as of Q3 2017.

Here are the key points. CenturyLink uses significantly more leverage than AT&T and its payout ratio is well over 100% -- two big red flags. While there's a lot more to a company's ability to pay its dividend than just a couple of metrics, CenturyLink's dividend certainly doesn't look like a safe one.

The Foolish bottom line

In a nutshell, the term "dividend trap" refers to the principle that if a dividend looks too good to be true, it probably is. As an income investor, it's important to look beyond an attractive high yield and focus on finding safe, sustainable dividends instead.

Matthew Frankel owns shares of AT&T. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.