How To Spot A Dividend Value Trap

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When looking for dividend stocks, it's tempting to gravitate towards securities with the highest yields. This is not always the best strategy; there's a lot more to a good dividend stock than a high yield.

Dividends are often offered by established companies, but dividends may also be used by new or in-trouble companies attempting to attract investors. A value trap occurs when investors are lured in by a high dividend yield, only to find the underlying company was not such a great buy after all.

The Value Trap

Some deals are too good to be true. Consider a used car dealer offering you a large discount on a car you're interested in. If the discount is too big, you begin to question the motives of the salesperson, and start wondering whether you're being offered a lemon. While at any given time there are potentially hundreds of stocks poised to provide a great return to investors, a very high dividend yield warrants further investigation.

The dividend yield is determined by taking the yearly dividend payment and dividing it by the stock price. For example, if the company pays $1 in dividends per year, and the stock price is $50, the dividend yield is 2%. Changes in the company's dividend policy and daily fluctuations in the stock price affect the yield.

The first sign of a value trap can be when you see a company paying a much higher dividend yield than its peers. When you see something like this, don't just accept it at face value. Take a closer look. Question whether the company has the ability to meet its obligations, and if it is being run in an efficient manner. If the stock price continually drops, or the company can't pay the dividend it promised, the high yield was just a trap.

Price Shocks and Trends

A sharp price movement will dramatically affect a stock's dividend yield, since yield moves inversely to price. Thus, surprise news announcement that drives the stock price down will increase the yield. It is up to the investor to determine if the price drop provides a good entry point - or is a sign to avoid the stock. If company fundamentals are strong, and over the long run the stock has performed well, such a price decline may be a good opportunity to pick up a well-paying dividend stock on the cheap.

On the other hand, a stock that continually drops in value, or is in a long-term downtrend warrants caution. As the stock price falls, the yield rises, making it appear attractive, but dividend gains are being offset by capital losses on the stock purchase.

Company Warning Signs

Before buying a stock that may be a dividend value trap, do a bit of research first.

The first step in your research should be to check the payout ratio. The payout ratio is how much of the company's net income is going to dividend payments. For example, if the company makes $1 million in profit this year, and pays out $200,000 in dividends, the payout ratio is 20%. If the company makes the same amount, but is paying out $2 million in dividends, the payout ratio is 200%, and the company is going into debt just to pay shareholders. A company that is paying out most of what it takes in, or more than it takes in, will be unable maintain the dividend for long, and may be heading toward (or already in) financial trouble. Learn more here about dividend payout ratio.

A value trap can also occur when earnings or cash flow growth is falling, yet the dividend yield is rising or remains elevated. When earnings and/or cash flow are declining, unless that trend changes, the company is unlikely to be able to maintain high dividend payments.

Little cash on hand is also an issue. Without cash, dividends can't be paid out, or the company must quickly attempt to raise cash, potentially adding to an already troubling situation. A high dividend means nothing if the company has no cash to meet its obligations.

Companies can also change their dividend policy at any time, but the changes may not be implemented right away. For example, company XYZ announces that it's ceasing dividend payments, but the announcement doesn't take effect until next quarter. For the current quarter the dividend yield looks attractive, but come next quarter the dividend yield will be zero.

Avoiding the Trap

Establish a baseline to determine if a stock has a high, low or average dividend yield. At the start of 2012, the average dividend yield of stocks listed on the S&P 500 index was 2.06%. In January, 2000 it was 1.16%; in 1982 it was 5.68%; and in 1932 it was 9.52%. These numbers show that the baseline can change significantly over time. Therefore, compare the stock's current dividend yield to a current average - such as the S&P 500 dividend average - to see if the stock's yield is out of the ordinary. Minor discrepancies are not an immediate red flag, although investing in any stock deserves in-depth research. For example, a 3.5% yield is not as alarming as an 18% yield if the S&P 500 average is near 2%.

When the stock market is in an overall decline, dividend yields will typically rise as stock prices fall. Therefore, you should note the overall direction of the stock market when determining whether the rise or fall in a stock's dividend yield is attributable to stock market direction.

Be wary of a company that is paying out more in dividends than its net income. Over the long-term, the company can't pay out more than it makes.

Be sure to also monitor fundamental performance. Lack of cash on hand, or declining earnings and cash flow, warn that the dividend may need to be reduced in the future if the declining performance continues.

Also, be sure to make note of any changes or announcements in dividend policy. This way, when a policy is implemented, it won't come as a surprise. Such information is found on the company's website in the investor resource section.

The Bottom Line

A dividend value trap occurs when a very high dividend yield attracts investors to a potentially troubled company. Not all companies that pay a high dividend yield are in trouble, but investors should question why a company is willing to pay out so much more than its peers. When something looks too good to be true, more research is warranted. The stock may indeed be great value, or it may end up being more trouble than it is worth.

Be sure to visit our complete recommended list of the Best Dividend Stocks , as well as a detailed explanation of our ratings system here .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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