3 ways to avoid falling into dividend traps | Smart Change: Personal Finance
Dividends can make investing in certain companies beneficial. Many dividend paying companies may not have the same hyper-growth potential as smaller and smaller companies, but they can be a great source of reliable income, which can be especially attractive to those of retirement age. If you are looking to become intentional in investing your earnings, you will need to do your best to avoid dividend traps.
The dividend trap is a dividend yield too good to be true and unsustainable. It’s not always easy to spot them, but doing these three things will definitely help.
1. Don’t just look at the dividend yield
Although it is the most commonly cited metric for dividends, dividend yields can be misleading. When companies determine their earnings, they generally do so as a dollar amount. If a company pays $1 in annual dividends and its stock price is $20, the dividend yield is 5%. However, if the stock price drops to $10 for whatever reason, the dividend yield is now 10%.
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If you don’t know any better, you can look at increasing your dividend as a reason to invest, without thinking about why the stock price is going down. Don’t let a higher dividend yield tempt you to lose sight of whether the decline was caused by something intrinsically weak in the company. If the company falters, it does not bode well because dividends remain strong.
2. Pay attention to the payment ratio
The payout ratio lets you know how much of a company’s dividend the company is paying out as dividends. You can calculate the dividend ratio by dividing a company’s annual earnings by its earnings per share (EPS). You can find these numbers when you look at a stock on your brokerage platform or from reports the company submits to the Securities and Exchange Commission.
If a company’s payout ratio is more than 100%, it pays more dividends than it does, which, I’m sure you can guess, is not a good thing. There is no “good” payout ratio globally because best dividend practices can vary greatly between industries, but in general, you’d probably want a ratio between roughly 30% and 50%.
If it is less, the company may not be as shareholder friendly as it would like, although there is more room to increase profits. If it is more than that, the dividend may not be sustainable, and it may mean that the company is not reinvesting enough money in itself. A company’s payout ratio can be affected by many things, including free cash flow, past earnings rates (companies aim to increase earnings over time), earnings stability, and other investment opportunities.
3. Know the company’s debt levels
There is nothing wrong with having debts on the company. In fact, sometimes, it makes sense for a company to take on debt because the return on the investment will be higher than the interest you pay. However, with risk comes debt, and at some point, a lot of it becomes a red flag, especially if debt is used to pay dividends.
By looking at a company’s debt-to-equity ratio — which is found by dividing its total debt by equity — you can get an idea of how much of the business is running on debt. You can find this information in the company’s balance sheet. Ideal debt-to-equity ratios vary widely by industry. Tech companies tend to have lower ratios (2 or lower), while other companies, such as those in manufacturing, tend to have slightly higher ratios. It is wise to be wary of any ratio that pushes the 5 to 6 mark.
Investing in dividend stocks can be a great way to make money. If you keep the above three tips in mind, you will increase your chances of avoiding profit traps.
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