Besides an increase in a stock's price, dividends are the other primary way investors can make money. Generally paid out quarterly from a company's profits, dividends allow investors to make money even if the stock price remains stagnant.
While higher dividend yields are a good thing in most cases, there are instances when too high a yield can be considered a red flag. Such a stock is called a dividend yield trap.
Here are three tips to help you spot and avoid dividend yield traps.
1. Understand that some things are too good to be true
Since dividend payouts are made from a company's profit, any money sent back to investors is money that's not reinvested into the company. Younger companies focused on growth, for instance, generally don't pay dividends because they'd rather use that money to help the company grow.
On the other hand, older, more established companies pay out dividends as a way to incentivize investors whenever their growth potential might not be as high.
If management is giving too much of its profit to shareholders instead of reinvesting it back into the company, that could be a cause for concern because it's taking away from growth potential. However, there are some exceptions, like real estate investment trusts (REITs) and master limited partnerships (MLPs). These companies have high dividend yields built into their structure and are required to pay most of their profit in dividends, so you shouldn't expect them to use as much capital to grow their businesses as other companies do.
2. Check a company's debt
A company's debt-to-equity ratio — which can be found by dividing its total debt by shareholder equity — gives insight into how much of its operations are financed through debt. Generally, the higher the debt-to-equity ratio, the more risk a company is taking. If a company has a lot of debt and pays out dividends, there's a higher chance that it will cut the dividend during tough economic times.
Some industries by their nature require more debt than others. That's why it's best to compare debt-to-equity ratios among companies within the same industry to get a sense of which ones have troublesome levels of debt.
It's also a red flag if a company takes on debt to keep its dividend going. Financially sound companies should be able to pay out dividends from their profits, not from taking on debt to please shareholders and keep them invested.
3. Look at the payout ratio
The payout ratio is how much of a company's earnings are going toward dividend payments. If a company earns $10 million and pays out $1 million in dividends, its payout ratio is 10%; if it earns $10 million and pays out $15 million in dividends, its payout ratio is 150%.
A payout ratio above 100% can mean that the company is taking on debt to pay its shareholders, which isn't good. Sometimes, though, high payout ratios are due to cash flow being higher than net income because of non-cash items that reduce net income on an accounting basis. But if a company is paying out more than it's bringing in, it will be hard for it to maintain its dividend over the long term, and the company could be in financial trouble (or headed there).
Dividends can be a great thing
Dividends are a great way to earn money from your investments, and if reinvested back into more shares of the company or funds, they can be a boost on the way to accomplishing your financial goals.
But everything that glitters isn't gold; make sure the companies you're investing in are sound in other aspects of their business and not just because they're offering a “lucrative” dividend payout. Dividends should be a bonus when you invest in a company, not the sole reason you do it.
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