Today we’re answering the question: What is a dividend value trap? In short, a dividend value trap is a company that appears to have a high dividend yield now, but it is not expected to last.
Let’s discuss.
What is a Dividend Value Trap?
A dividend value trap seems very straightforward, but they can be tricky to identify. Missing a dividend value trap can be result in serious losses.
A dividend value trap occurs when a company appears to have a strong dividend yield, generally well above 5%. However, future performance of the company is forecast to be poor and the dividend payments may not last.
The “Value” part of a dividend value trap simply implies that the company appears undervalued due to its dividend. However, in reality, it is not undervalued due to other circumstances.
When using a stock screener, you may see some outlier companies with outsized dividend yields. In many cases, these are too good to be true and there are some underlying issues.
A prudent investor needs to understand the underlying context of a dividend payment and its future safety.
Examples Dividend Value Traps
I’ve provided below a few of the common dividend value traps you can find.
Shrinking Earnings
The most common dividend value trap occurs when a strong dividend paying company starts reporting shrinking earnings. Because of these poorer earnings, the share price drops.
However, for whatever reason, management decides to keep their dividend the same. The dividend payout ratio vs. earnings per share could jump up from, for example, 50% to 100%. But because the share price dropped and the dividend remained the same, your yield on the dividend increased.
This looks good at first, but it is extremely unlikely that the company will continue to pay a 100% payout ratio. It is therefore quite likely that the dividend will be cut.
As an investor, you need to understand future dividend safety and if you think a dividend is sustainable. This can be done by understand EPS forecasts and general financial growth prospects.
Dividends Sustained by Cash Surpluses
Dividend value traps can be tricky because, for many companies, they may keep paying dividends that are greater than earnings for some time. This means they are paying from cash on hand, rather than from earnings.
Some companies can sustain this practice for several quarters, or even years, as they want to keep paying dividends to save face. Many times, these companies will have dividend yields well over 10% to 20%.
These dividend yields are likely too good to be true. It is highly likely that the company will never actually return to a level of profitability to sustain that dividend.
As such, you will earn some good dividends for a few quarters or years, but the company will simply go under or cut the dividend completely.
Special Dividends
This is luckily an easier one to spot. Most companies pay a regular dividend at some fixed amount. Occasionally, if they have a very profitable quarter, they will issue a special dividend in addition to their regular dividends.
These special dividends, depending on their size, can upwardly distort the future ongoing dividend yield. Luckily, many websites track dividend history and special dividends, so you can adjust these out and get the true “ongoing” dividend yield.
Book Profit vs. Cash Flow
This is a tricky one. Some companies, due to GAAP, can go long periods of time reporting positive book profits, but negative cash flow from operations. This is generally due to large capital expenses that are not expensed immediately, but depreciated over its useful life.
Because of this, you may see a company reporting strong earnings per share (book profit) and a reasonable dividend. However, due to cash constraints, that dividend may be at risk of being cut or ceased all together.
Make sure to pay attention to the cash flow from operations of a company as well as its book profit. Both should be strong enough to sustain the dividend you’re expecting.
Bottom Line
A dividend value trap can be a fairly simple issue to spot, but failing to do so can cause major issues for your portfolio. By applying the steps above, you can hopefully screen out dividend value traps and keep your portfolio clean!
Thanks as always for reading!
DISCLAIMER – THIS ARTICLE IS NOT FINANCIAL ADVICE. THIS ARTICLE DOES NOT CONSTITUTE A BUY, SELL, OR HOLD RECOMMENDATION ON ANY SECURITY MENTIONED HERE. THIS ARTICLE CONSTITUTES MY OPINION AND NOT A STATEMENT OF FACT. ALL INFORMATION REGARDING THE FINANCIAL SECURITIES MENTIONED IS ACCURATE AS OF JANUARY 24, 2024. DO YOUR OWN RESEARCH.