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How to avoid dividend traps

Morningstar  |  03 Jul 2012Text size  Decrease  Increase  |  

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The following article is part of an ongoing educational series. The previous article can be found here.

 

Investors may often ponder whether or not a stock's dividend stream alone really helps to know whether or not it is a good investment.

Or, putting it another way, is a stock that produces a high dividend in relation to its share price a good investment?

The answer is no.

Dividend levels and dividend yields can mean any number of things, and changes in dividend yields simply provide a convenient starting point for asking further questions about the company's operations.

Here are some ways dividends and dividend yields can be utterly misleading.

A company that makes high dividend payments relative to its earnings (has a high payout ratio) may be in a mature business and unable to find any significant growth options on which to spend its profits.

It does not necessarily mean the company is struggling to maintain its dividend, and may be fine if you are seeking an income stock.

A company that pays a very low dividend or no dividend at all may be in an early stage of business where it needs to reinvest all profits back into growth.

Therefore, short-term dividends for shareholders are deferred in order to generate long-term value for shareholders - a positive.

A company that records a jump in its payout ratio (that is, it is forced to pay out a large proportion of its earnings as dividends) may be struggling to maintain its dividend at current levels.

This is a clear warning signal that needs investigation.

A stock's dividend yield is calculated by dividing its latest dividend by its current share price. A high yield is not necessarily a good thing, because it may simply reflect that the stock's share price has declined (the lower the share price, the higher the yield).

This would indicate the market is not anticipating significant growth in earnings.

In the example mentioned in our previous article, the decline in GUD Holdings' (GUD) share price drove its dividend yield to around 9 per cent immediately before the company announced it could not maintain its dividend - and the share price took a beating.