Warning signs of a yield trap
There are several warning signs that an investment could be a yield trap. Look for these red flags:
High payout ratio
A dividend payout ratio is a company's total annual dividend payments divided by its annual earnings. For example, if a company earns $50 million and makes $20 million in dividend payments, its payout ratio is 40%. Payout ratios vary widely by industry, but historically, a safe payout ratio has been in the 30% to 55% range.
A high payout ratio often isn't sustainable. Be especially cautious if a company's payout ratio is higher than 100%, because that means it's paying out more in dividends than it's raking in.
Falling stock price
Yields move inversely to stock prices, so if a stock's price drops dramatically, it will push up the dividend yield. Sometimes, a steep price drop presents an opportunity to pick up an undervalued stock. But before you invest, examine the company's fundamentals. Make sure you're not just investing to earn a high yield.
Rising debt
If a company has growing debt or its debt levels are unusually high compared to similar companies, it may not be able to sustain its dividend. To get a snapshot of a company's debt load, you can calculate its debt-to-equity ratio by dividing its total debt by total shareholder equity. (You can find this information on the company's balance sheet.) As with other financial ratios, this number is most useful when you compare it against companies in the same industry.
Weak cash flow
Declining free cash flow or negative cash flow indicates that there's less money available to pay dividends. If a company has to borrow money or sell assets to continue dividend payments, it's a sign that the dividend may not be sustainable in the long run.
How to avoid value traps
Avoiding value traps mostly boils down to doing your due diligence. Here's how to avoid getting snared in a yield trap:
- Be skeptical of any company that has an unusually high yield compared to its peers.
- Look for businesses that are growing their revenue and earnings, have manageable levels of debt, and that don't have unusually high payout ratios.
- Though past dividend history doesn't guarantee future dividends, look at the past five to 10 years of dividend payments to see if the business has ever slashed its dividend.
- Consider dividend ETFs instead of dividend stocks. Because you're spreading out your risk across many different companies, there's less danger compared to individual stocks.
