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WHEN A DIVIDEND TRAP IS ABOUT TO SPRING

By John Persinos • October 21, 2024 • Stocks to Watch

Printable PDF

When looking for dividend stocks, it’s tempting to gravitate towards securities
with the highest yields. This is not always the smartest strategy; there’s more
to a worthwhile dividend stock than just a high yield.

Sure, robust dividends are offered by well-known companies with solid balance
sheets. But high dividends also can be used by new or inherently weak companies
as bait for investors.

A “dividend trap” is when investors hungry for yield are suckered into a high
dividend yield, only to eventually discover that the underlying company is
deeply troubled. That’s when the dividend gets cut or eliminated and
unsuspecting investors get stung.

Income-hungry investors have piled into high-yielding stocks without always
subjecting them to critical analysis. Investment publications and websites tout
all sorts of intriguing high yielders, ranging from business development
companies and mortgage finance firms to tanker owners and energy plays.

Read This Story: Why the Payout Ratio Can Be Misleading

Stocks that pay sizable dividends can be compelling investments, and in many
cases, they may even be relatively safe. However, the field of big yields
requires careful analysis to avoid pitfalls.

A company that can’t fully support a high dividend is only one bad quarter away
from being trampled by the market. The trick is to take a few simple steps to
identify companies whose dividends are both attractive and sustainable.

Step 1: Determine if a company consistently earns enough to meet its dividend.
Since earnings can be lumpy from quarter to quarter, it’s best to see whether a
company’s full-year earnings consistently cover the payout, with sufficient
money left over to finance future growth. If earnings fail to exceed the payout,
the dividend probably isn’t sustainable and could be cut at the first sign of
trouble.

Step 2: Look at the company’s payout ratio, or how much of its earnings are
being paid out in dividends. That number is easily calculated by dividing the
total dividends paid in any year by full-year earnings per share.



The result will give you a good idea of how far earnings can fall before the
dividend would have to be cut. For instance, a company with a payout ratio of
60% could see its earnings fall by 40% before the dividend is in real danger.

What constitutes a healthy payout ratio depends on the industry, but on average,
a good upper range is between 50% and 70%. A payout ratio much higher than that
is an indication that the company isn’t investing in itself, thus stifling
future growth potential as well as the prospect for an eventual increase in the
payout.

A higher payout ratio also leaves a company little room for error in terms of
earnings. One bad quarter could force it to borrow to cover the dividend or even
resort to a dividend cut. If the payout ratio jumps above 100%, in most cases
the company is either dipping into cash reserves or taking on debt in order to
make its payout. In either case, that’s a red flag that the dividend is in
danger of being cut.

Step 3: Look at the payment history. A consistent track record of maintaining
the dividend in good times, as well as bad, indicates a dividend cut is
unlikely. If a company has a long-term record of consecutive dividend increases,
even though the boost in payout may have varied, it’s a strong indication that
management is committed to returning cash to shareholders.

While there are additional measures required to fully evaluate a dividend-paying
company, these few simple steps will help you avoid the worst of the dividend
traps.

Knowing your risk tolerance will help you decide which investment strategy is
right for you. For example, if you have a low risk tolerance, you may want to
emphasize safe haven investments even though your time horizon indicates you
could be more aggressive.

If you’re investing for income, your focus should always be on the health of the
underlying business. The best dividend stocks are the ones that are in good
shape and growing, so they can maintain and raise their payouts.

WATCH THIS VIDEO: Jim Fink Reveals the Keys to Unlocking Wealth

PS: Our colleague Jim Fink has made a fortune for himself trading options. Now
that he’s a millionaire, he’s ready to tell all.

As chief investment strategist of Velocity Trader, Jim Fink has devised a
methodology that generates market-thumping gains…in up or down markets and
regardless of political uncertainty.



One of the most important presidential elections in our lifetime is just around
the corner. Many investors are nervous and hunkering down. But not Jim.

In a new presentation, Jim Fink explains the simple strategy he uses to rake in
gains of 104%, 164%, and 203%…in as little as 72 hours.

Can Jim’s election-year trades really be this profitable? Click here to find
out.

--------------------------------------------------------------------------------

John Persinos is the editorial director of Investing Daily.

To subscribe to John’s video channel, click this icon:

 


ABOUT THE AUTHOR

John Persinos
Bio | Archive
John Persinos is the editorial director of Investing Daily, overseeing such
publications as Personal Finance, Utility Forecaster, Profit Catalyst Alert,
Rapier's Income Accelerator, Income Forecaster, and Marijuana Investing Daily,
among others. John also writes the Mind Over Markets daily stock market recap,
and he's the chief investment strategist of Marijuana Profit Alert.

 
John has decades of experience in the technology and political realms. He has
worked as a staff editor at Inc. and Venture magazines, and written for
Kiplinger's, Street Authority, Investing Answers, and TheStreet.com, to name a
few. In a career that has spanned more than 40 years, John has been diligently
and prolifically covering the news and its impact on investors.

 
John also has experience with the inner-workings of Capitol Hill, serving as a
press secretary to U.S. Rep. Byron Dorgan (D-ND). John started his career as a
daily newspaperman with The Orlando Sentinel.

 
John holds undergraduate and graduate degrees from Boston University. He also
completed the Davenport Fellowship in Business and Economics Reporting at the
University of Missouri (Columbia).

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