Tutorial: avoid a dividend trap
Yield rises when the price falls. The biggest yields are the market shouting that it does not believe them.
Buy income that survives, rather than income that is about to be cancelled.
How avoid a dividend trap works, in one picture
The same argument as the text, as a chain. Each step is what makes the next one possible.
The divergence that precedes most disasters
Reported profit climbing while the cash it supposedly generated goes nowhere. Either customers are not paying, or the sales were never really made.
- 1
Understand where a big yield comes from
Yield is the dividend divided by the price. Note the denominator. A 12% yield usually is not generosity, it is a share price that has collapsed while the dividend has not yet officially been cut.
- 2
Check the payout ratio
Dividends divided by earnings. Below about 60% is comfortable. Above 100% means the company is paying out more than it earns, funding the difference from reserves or borrowing, and that is the single clearest early warning of a cut.
- 3
Then check it against cash, not earnings
Earnings can be shaped. The dividend is paid in cash. Compare the total dividend against free cash flow. If free cash does not cover it, the payment is being funded by something that will eventually run out.
A company that borrows to pay its dividend is liquidating itself politely.
For every income holding, you know the payout ratio and whether free cash flow covers the payment.
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Yield rises when the price falls. The biggest yields are the market shouting that it does not believe them.
We screen for yield AND the balance sheet behind it, because the biggest yields belong to the companies least able to pay them.