Dividend investing is a fantastic way for individuals of all walks of life to reach financial independence, but we do not want to invest in a dividend yield trap. While dividends are a good way to “extract” cash from companies in your stock portfolio, not all stocks are suitable candidates for dividend investing.
The dividend yield of a stock works both ways. It can increase if either the dividend payout increases or if the stock price decreases. When stock price decreases and dividend yield goes up, it could be an attractive opportunity to invest. However, if the stock price decrease is due to fundamental issues with the company underlying business, this could mean that we are buying into a dividend yield trap.
Here are 5 warning indicators to spot for dividend yield traps while hunting for the right dividend stocks.
1) Negative Cash Flow
Cash flow is king, Simply put, cash flow is the difference between the money coming into a business and the money going out of the business. We can determine if a company’s dividend is sustainable by considering the company’s ability to generate cash flow. If a company’s cash flow is deteriorating or it’s taking enormous amounts of debt, its ability to pay a dividend is also deteriorating.
2) Weakening Business Fundamentals
If the high dividend yield is due to a rapid decline in the stock’s price, it’s a good idea to look into why the stock’s price dropped so much. That’s because the company’s dividend yield is growing more attractive to yield-hungry investors. But if these investors don’t look under the hood to uncover the real reason for rising dividends, they could be in a heap of trouble when the company ultimately can’t maintain its payouts and cuts the dividend.
Quarterly financial reports reveals which companies can sustain their dividend payments. When a company has weak fundamentals, it can’t rely on sales growth or earnings growth to improve its cash flow. Instead, it must look at what it can cut to make up the difference and free up cash. It is highly likely that they will cut dividends.
3) Credit Downgrades
Downgrades happen when the future prospects of a company deteriorates. It could be due to the material or fundamental change in the company’s operations, outlook or industry. Credit agencies like Moody’s and S&P will issue a downgrade of the company’s security.
Companies do not want this to happen. A credit rating cut means that they are at risk of higher borrowing costs when they issue new debt. So, when a credit downgrade does happen, companies often slash their dividend to preserve cash flow. This would also preserce its credit rating. A good example would be Singtel. In 2019 when their ratings got downgraded, there were rumours about the potential of dividend cuts.
4) Excessive Debt
It doesn’t make sense for a company to have high dividend payouts when they can use the cash to reduce their debt. To me, it signifies that the management is more interested in shoring up its share price and lining their pockets. Rather than keeping the best interests of the shareholders at heart.
The more debt a company has, the more likely it will need to cut its dividend during a tough economy. An effective way to evaluate a company’s debt load is to look at its debt to equity ratio or interest coverage ratio.
5) Dividends Greater Than Earnings
The metric that I use to check the sustainability of the dividends is the dividend payout ratio. This is calculated as a company’s annual dividend payout rate divided by its earnings. A high payout ratio — especially over 100% — may indicate that a dividend isn’t sustainable. This means that the company isn’t earning enough profits to pay its dividend. They may also be financing it through debt or other means. Again, management doing so might not have the best interest of the company nor its shareholders at heart.
Examples of Dividend Yield Trap
General Electric (NYSE:GE)
As we can see from the chart above, GE started to have negative earnings and dividends became unsustainable. This led to GE slashing their dividends from 2018 onwards.
A more familiar stock in Singapore, Starhub was once touted as a stable dividend play. This was before their business fundamentals start to deteriorate. Their underlying business became competitive. Things were not made easier with the introduction of the 4th telco company vying for market share in Singapore.
From the chart above, we can see that earnings were somewhere consistent with the dividends per share. However, free cash flow per share was on a downtrend.
From 2015, Starhub began to report lower EPS yoy. Share prices began to fall from its 2014 highs of >$4 to less than $2 per share in 2018. There were alot of discussions of its sustainability of dividend payouts and you can see that investors are attracted to its very high dividend yield. However, as earnings were lower yoy and dividends were cut, it also brought down the dividend yield. This has resulted in many investors getting stuck with a dividend yield trap.
A high yield doesn’t necessarily mean that a stock is a good income investment. So we must be sure to look beyond the yield before investing. Just remember that if a stock’s dividend yield looks too good to be true, it probably is. Excessive dividends are often unsustainable or result from a company taking on an excessive amount of leverage which might lead to more trouble for the company. We do not want to invest in a dividend yield trap.
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