Beware Of The Dividend Yield Trap

A dividend yield trap or a dividend trap is one that takes place where a company’s dividend yield is much higher than it can possibly sustain.

There are two things that could possibly lure any serious stock investor into parting with his funds for a security. The first is the expectation of growth or an overall increase in value, and the other is based on expected dividends.

The investor who is particular about receiving dividends might require dividends to form part of his or her income streams or might just be one interested in amassing immediate gains. Whatever the case may be, various stocks indeed have their differing prospects when it comes to the payments of dividends.

Some pay less, focusing on reinvesting profit for growth, while others pay relatively high dividends as a way to pacify investors for the slow growth in the value of the security. For the dividend-oriented investor, while it is okay to find companies who would meet his or her needs the best, there is also a need to be conscious and cautious of the dividend yield trap.

The dividend yield trap, much like any trap, is one that promises you the good stuff. By showing you more of what you can gain based on their dividend yields, a company can distract you from all other wider issues until it is too late.

A dividend yield trap or a dividend trap is one that takes place where a company’s dividend yield is much higher than it can possibly sustain. The dividend is usually high yielding with large pay-outs that are too good to be true.

In addition, the stock price of the company might also decline rapidly, making the price to earnings ratio seem lower than it really is. This decline in stock price might be as a result of issues going on in the business. These are the very issues that are covered by the enticing dividend yield.

For investors who have spent time in the market, this might be something they can look beyond; however, the investors who are not conscious of the ploy, may end up chasing after the gains until the company cannot grow without cutting its dividends in which case it is really late – you lose both on the growth level and the dividend level.

There are a range of ways for you to spot dividend traps. For one, dividend traps are typically sustained by high debts that have been taken by the company. Generally, companies that have too much debt would most likely cut their dividends when the company is down. Hence, when a company is heavily leveraged, beware – even when the dividend yield looks good.

Another way to know a dividend trap from a mile away is that the earnings of the company and its dividends do not match. A company with high earnings is allowed to give high dividends. When the dividend yield is higher than what you believe the company would be able to offer conveniently, you need to be wary.

A pay-out ratio is a ratio that can guide this. The ratio shows a stock's dividend as a percentage of its earnings. A company should not spend more than it earns. If it earns N50,000, it should not be able to pay dividends more than that.

In fact, it is safer to have pay-out ratios that are 50% or less. Meaning the company is paying dividends out of a full reservoir. In other words, for earnings of 50,000, it shouldn’t pay more than N25,000 to its shareholders.

Where a pay-out ratio is well in excess of 100%, it becomes apparent that the company is paying out more than it earns and cannot be sustained.

Finally, a dividend trap could also be apparent when a certain industry should ordinarily not give that level of dividend anyway. If it seems higher than what that industry would offer, it is only a matter of time (which is most likely the near future) that it adjusts its position to ensure it is still standing.

It is advisable to invest with a goal of growth of your investment. However, where you want to focus on periodic dividend gains, be wary of the dividend trap.

Written by Lawretta Egba.