3 ways to avoid falling into the dividend trap ()

Important points

  • Dividends can be misleading.
  • The payout ratio is crucial.
  • To take on debt to pay off
  • Dividend is a red flag.

Dividends can make it worthwhile to invest in certain companies. Many dividend-paying companies may not have the same hyper-growth potential as younger, smaller companies, but they can be a great source of reliable income, which can be particularly appealing to retirees. If you want to consciously invest in dividends, you should avoid dividend traps as much as possible.

A dividend trap is a dividend that is too good to be true and is unsustainable. It is not always easy to spot them, but if you have these three things in mind, it will definitely help you.

1. Do not just look at the dividend yield

Despite being the most commonly cited dividend measurement, dividend yields can be misleading. When companies determine their dividends, they usually do so as an amount. If a company pays an annual dividend of $ 1 and its share price is $ 20, the dividend yield is 5%. But if the stock price drops to $ 10 for some reason, the dividend yield is now 10%.

If you did not know better, you could look at the higher dividend as a reason to invest without considering why the stock price has fallen. Do not let a higher dividend fool you into ignoring whether the stock’s decline is due to a fundamental weakness in the company. If the company falters, it does not bode well for high returns.

2. Pay attention to the payout ratio

The payout ratio tells you how much of a company’s earnings are paid out as dividends. You can calculate the payout ratio by dividing a company’s annual dividend by its earnings per share. share (EPS). You can find these numbers when you look at a stock on your brokerage platform or in the reports a company submits to the Securities and Exchange Commission.

When a company’s payout percentage is above 100%, it pays out more dividends than it earns, which, as you can imagine, is not good. There is no uniform payout ratio as best practice for dividends can vary widely from industry to industry, but in general you should aim for a ratio of between around 30% and 50%.

If it is lower, the company may not be as shareholder-friendly as you would like, but there is more room for an increase in dividends. If it is above that, the dividend may not be sustainable and the company does not reinvest enough money in itself. A company’s payout ratio can be affected by many factors, such as: B. through free cash flow, past dividend rates (companies want to increase their dividends over time), earnings stability and other investment opportunities.

3. Know a company’s debt level

It does not matter if a company has debt. Sometimes it even makes sense for a business to take on debt because the return is higher than the interest rate it pays. But debt also comes with risks, and at some point, too much debt is a red flag, especially when the debt is used to pay dividends.

If you look at a company’s debt ratio – it is calculated by dividing the total debt by equity – you can get an idea of ​​how much debt the company has. You can find this information on a company balance sheet. The ideal debt level varies widely depending on the industry. Technology companies tend to have lower odds (2 or less), while other companies, e.g. B. from the manufacturing sector tend to have slightly higher quotas. However, it is advisable to be careful with the ratio 5 to 6.

Investing in dividend stocks can be a great way to make money. By following the three tips above, you increase your chances of avoiding dividend traps.

Article on 3 ways to avoid falling into the dividend trap first appeared on The Motley Fool Germany.

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This article was written by Stefon Walters and was published on Fool.com on 6/8/2022. It has been translated so that our German readers can participate in the discussion.

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