Why You Should Watch Out for Dividend Trap Stocks

As an income generating investor, you know the importance of stocks that can consistently pay out dividends from their cash flows from operations and still have lots left over to finance their operations, pay their workers' salaries, pay for general & admin expenses and more. In fact, if you own stocks that generate billions of dollars in cash flows every year, you would be better off in your return on investment (ROI) than those companies that pay no dividends, hence only allowing investors to make capital gains if the stocks appreciate in value. So how do you find good companies that pay reasonable dividends, based on the dividend yield? Well for a start, use the sidebar on the left to surf through companies by Sector, by Industry or by Market Capitalization to find companies that interest you.

If you are wondering what the dividend yield is, it is a measure of how much income you should expect to derive from your stock relative to the current price of the stock. Another way to look at it is dividend yield is a way of calculating your return on your investment (ROI). The formula for calculating the dividend yield is:

Dividend Yield = Annual Dividends per Share / Current Stock Price

The Dividend Trap

If you inspect the dividend yield formula above, you will see the denominator is the Current Stock Price which fluctuates day to day based on economic news & market data, company's earning reports, operations & news coming from the company as well as other rational market factors. Thus, if a company's stock price is dropping like a bomb, the dividend yield will skyrocket because the denominator is a lower value, thus the numerator will be higher. For instance, if Coke is trading at $50/share as of July 2010 and the company's annual dividend is $1/share, here's how the dividend yield would look like:

Dividend Yield = $1 / $50
Dividend Yield = 2%

Now imagine if Coke reported a very bad 3rd quarter of 2010 where it missed analyst estimates of net income by 5%. And assume investors are not very happy about this and selloff Coke's stock leading it to close at $42.50. Now what does the dividend yield look like?

Dividend Yield = $1 / $42.50
Dividend Yield = 2.4%

Notice that because of the drop in stock price, Coke's dividend has gone up from 2% yield to 2.4% yield; such is an example of a dividend trap. In a recession where stock prices plummet, you may be tempted to buy companies with accidentally high yielding dividends; well you have to watch out for a dividend cut because if the company is not making money during the recession, it might not be able to keep paying its dividends. When buying a high dividend yielding stock, you should ask yourself these questions:

i) What do the stock's & company's business fundamentals look like?

ii) Is the company's earnings growing or falling, as dividends are paid directly from cash which comes from earnings. Is the current earnings sustainable to keep paying dividends or will it be cut?

iii) Does the company have a consistent history of paying dividends & earnings growth? If no, do your due diligence!

iv) If the company has recently acquired another company, how did it finance its acquisition? Did it make a huge cash payment from its cash reserves or borrow money from banks or by issuing bonds payable?

v) If the company did make the acquisition from its cash reserves, will it have enough cash left to be able to pay the dividends or will it be forced to cut?

Video: General Electric to Cut Dividend from $0.31/share to $0.10/share - Bloomberg

Watch this useful video of how General Electric (GE) cut its dividend from $0.31/share to $0.10 in order to save $9 billion annually. The analyst in the video says GE might have done this so it can have an extra $9 billion to inject in to GE Capital which is a diversified financing solution provider serving consumers, retailers and businesses around the globe. Due to the economic downturn of banking & financial stocks in 2008 and 2009, GE Capital has been under immense pressue due to mortgage writedowns & loan losses. Perhaps this is the reason why General Electric is cutting its dividend; to help out its subsidiary GE Capital.

General Electric is featured in our high dividend paying stocks by Conglomerates sector category & Utilities industry.