Hey investors! Be careful about dividend traps!
What is a dividend?
Dividends, the regular cash payouts from companies to shareholders, can be a tempting lure for investors.
A dividend is a portion of a company's Net Profit After Interest and TAX that is distributed to its shareholders (owners). It is essentially a way for a company to share its financial success with the people who own pieces of the company (the shareholders).
Dividends are not guaranteed as the company’s Board of Directors (BOD) decides whether or not to pay a dividend, and how much. Dividends are typically paid out on a regular basis, like monthly, quarterly, semi-annually or annually.
If a dividend is not paid, the business will retain all of its Net Profit After Interest and TAX in the businesses as a source of finance for future use.
What are dividend traps?
Some seemingly attractive very high-dividend stocks now can turn into nasty dividend traps later.
A dividend trap is a situation for investors looking for income through dividends. It occurs when a company's stock price and its dividend payout both decrease over time.
These traps offer a high upfront yield, but the company’s fundamentals are weak, making the dividend unsustainable in the long-term.
This will potentially lead to a decline in the stock price in the near future.
What causes a dividend trap to happen?
This can happen for a few reasons:
- Paying too much dividends from profits. The company might be paying out a large portion of its profits as dividends, which is not sustainable in the long run. This can leave them with less money to invest in growth and eventually hurt their future earnings.
- Borrowing money to pay dividends. A company with a lot of debt might use dividends to attract investors. But if they are struggling to make debt payments, they may be forced to cut dividends in the future.
- Not using sustainable profits to pay dividends. Sometimes, companies that are not actually making enough profit will use accounting tricks to pay dividends. This obviously cannot last forever, and eventually the dividend will likely be cut.
That is why it is important to look beyond just the yield and understand the health of the company as a whole.
Signs of dividend traps in a business
Here is how to spot and avoid these dividend traps.
Immediate red alerts that a stock might be a dividend trap:
- High Dividend Yield. A yield that seems too good to be true, typically above 6%, warrants caution. While some established companies offer high yields, for most companies, it suggests they might be prioritizing payouts over reinvesting in growth.
- Unsustainable Payout Ratio. This ratio shows what percentage of a company’s earnings are paid out as dividends. A ratio exceeding 70% is high, and above 100% is a major red flag. It indicates the company is funding dividends with debt or dipping into cash reserves, practices that can’t be sustained.
- Lack of Cash Flow. Even if a company has a high payout ratio on paper, check if they actually have the cash on hand to support the dividend. Companies that borrow heavily to pay dividends are likely setting themselves up for trouble.
Future trouble signs that a stock might be a dividend trap:
- Low Return on Equity (ROE). ROE measures how efficiently a company generates profits from shareholder equity. A minimum ROE of 15% is a good sign. A lower ROE suggests the company might not be using its capital effectively, raising questions about its ability to maintain dividend payments.
- Declining Earnings. A company with consistently declining earnings is not a good long-term investment. Check the company’s cash flow forecast to gauge how well they can manage future obligations, including dividend payments.
- High Debt-to-Equity Ratio. This ratio compares a company’s debt to its shareholder equity. A ratio ideally below 1 indicates a healthy balance sheet. Avoid companies with a ratio of 1.5 or higher, as they might be struggling to manage their debt and could be forced to cut dividends.
By keeping these warning signs in mind, you can avoid dividend traps and focus on companies with strong fundamentals and sustainable dividend policies.
Remember, a healthy and growing company with a moderate dividend yield is often a better long-term investment than a high-yielding dividend trap. It is because companies with a history of paying consistent dividends are generally seen as more reliable and attractive to investors.
