Dividend stocks, yield traps, and red flags
By Tanner Yarton
Introduction:
Investing past indexes and ETFs can look drastically different depending on ones financial goals and portfolio objectives. For the purposes of this article, I will be focusing on the popular, historically significant strategy of dividend investing. In short, dividend investing is a method of buying stocks of companies that make regular cash payouts to shareholders as a reward for owning their stock. Dividends are usually quarterly payments, with some companies offering special one off dividends as an added bonus.
For example, if a stock is $100 and the company pays a 2.00% dividend (quarterly payout), the culmination of payments made on the stock will add up to $2.00 per year, or $0.50 per quarter. Now, its easy to assume that with these simple metrics in mind, you would want to look for the highest paying dividend companies, but that’s not always the case.
In this article we will go through some key red flags that can be observed before purchasing a dividend stock. While this is labeled as an introductory article, I will be covering some basics of a financial statement and more in depth research than simply googling a stock, checking the price and buying. It is also worth noting that a company showing one of these flags *can* be ok, but if multiple flags are displayed, it might be worth rethinking.
#1: Egregious debt
In no particular order, we will start with a company’s debt. While this varies from market sector to sector, looking into a company’s debt is an easy first step to generalize its health. I look for the Debt-Equity ratio which can be found on a companies balance sheet or a simple google search. Unfortunately, there isn’t a magic number that all companies should follow, so its recommended to compare a company you may be interested in with its competitors or other businesses in a similar field. A quick example of the variation that may occur is a tech company vs a real estate company. To generate the cash flow needed to pay a dividend, tech companies traditionally take on less debt, than say a real estate firm that needs to take on considerable debt to acquire enough paying properties to pay dividends. Again, there is no simple number to look for but 1-1 is a good place to start.
#2 Unusual yield
Unsurprisingly, if a dividend yield looks too high, it probably is. as a rule of thumb, if a companies dividend is between 1 & 4%, its probably nothing to be too concerned about. Anything higher and its worth looking into. A great example as of late are some shipping companies. After the pandemic, shipping rates skyrocketed, generating enormous profits, and subsequently dividends for some of the companies that benefitted the most. ZIM 0.00%↑ for example, paid nearly a 60% dividend through 2021. Unfortunately, since then the loss incurred on the stock price and cut dividends have made this a poor investment in the long run. Its always important to check on the field of the stock and reasons why their dividends may be so high before purchasing. Another example I mentioned in #1 is real estate investment trusts, or REITS. They take on considerable debt but usually pay anywhere between 4-8%. A bit riskier, but something many dividend investors have in the portfolio. O 0.00%↑ is a good one to look into as a starting point.
#3 Payout Ratio
A company’s payout ratio is the relation between its earnings per share and how much of those earnings are paid in dividends. for example if a company earns $0.25 and pays a $0.05 dividend, their payout ratio would be 20%. Some real estate companies can get away with over a 100% payout ratio, but that’s because it can be sustainable since their operational revenue takes into account depreciation which many other companies don’t have. As a rule of thumb, over a 100% payout ratio should be a red flag. In addition to this, its crucial to look past the last year. Acquisitions can distort earnings and cause for a weird looking payout ratio.
#4 Free cash flow/dividend
Another simple metric to look for is a company’s free cash flow and its relation to its dividend. If a company’s dividend is greater than its free cash flow, its possible that the company may be taking on debt to pay the dividend. This is obviously a terrible sign.
#5 slowing dividend growth
Finding mature company’s that have strong dividends is obviously great for a dividend portfolio. It is equally as important to find company’s whos dividends continue to grow into the future. Slowing dividend growth can signify that that business is losing its ability to grow earnings, which could be a sign of slippage in its future dividend payouts, slowing the growth of both your payouts and the share price.
#6 Leveraged ETFs
While this isn't related to companies themselves, stocks like JEPI 0.00%↑ are actively managed ETFs that utilize leveraged vehicles such as stock options to generate greater returns and higher dividends. JEPI 0.00%↑ pays a staggering 11% dividend as of the date this article is published. IF you are unfamiliar with covered call options writing and the strategies utilized in these products, I personally would not touch them.
That’s all for this one. I hope this article helps to make determinations for those looking to get into dividend investing.
If you have any suggestions for future articles, feel free to leave them in the comments below and I will add them to my list of content.
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Tanner