A dividend trap is a high-yield dividend stock whose payout is simply too good to be true or to be sustainable. Often, dividend traps have high debt loads, unsustainable payout ratios, and other red-flag metrics. Many times, the reason for the high yield is a massive drop in the stock price due to trouble in the business.
Ways to spot a dividend trap
The most obvious way to spot a dividend trap is by a dividend yield that looks too good to be true -- specifically, a dividend yield that doesn't make sense within a certain industry.
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For example, real estate investment trusts, or REITs, typically pay dividends in the 4%-7% range. So, a REIT with a 6.5% dividend wouldn't necessarily be a red flag. On the other hand, bank stocks pay an average dividend yield of just 1.4% as of this writing, so a bank stock with a 6.5% yield might be a sign of a dividend trap.
To be clear, this isn't a foolproof way of spotting dividend traps. However, it's certainly an indication that you should take a closer look into the fundamentals of the stock before investing.
Here are a couple of things that generally mean you should stay away.
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Lots of debt -- Stocks that carry too much debt are more prone to cutting their dividends during tough times. A good metric to look at is the stock's debt-to-equity ratio. Generally speaking, an ideal debt-to-equity ratio will be below 1, but slightly higher is often OK. Debt-to-equity ratios tend to vary considerably between different industries, so this is most effective when used to compare a stock to others in the same industry.
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Dividends exceed earnings -- A payout ratio is a stock's dividend expressed as a percentage of its earnings. For example, if a stock earns $5.00 per share and pays a $2.00 dividend, its payout ratio is 40%. I like to see payout ratios of 50% or less, with the exception of REITs which are required to pay out most of their earnings. In any case, a payout ratio in excess of 100% means that a company is paying out more than it earns, which is generally unsustainable.
A potential dividend trap versus a solid dividend stock
To illustrate this concept, let's take a look at two telecommunications stocks: CenturyLink (NYSE: CTL) and AT&T (NYSE: T). Now, this isn't exactly an apples-to-apples comparison, but the general business fundamentals should be similar.
Just looking at the dividend yield, CenturyLink's 12.2% dividend yield is more than twice AT&T's 5.3%. An income investor, at first glance, may be more inclined to go with the former. However, pay attention to some of the key metrics: