What is the dividend trap? An illustration will explain the concept.
Imagine that your family is the controlling shareholder in a retail jewelry store called Super Luxury Jewelry (SLJ). Prior to the crash, your firm earned $10 million in net income and Wall Street gave you a p/e ratio of 15, resulting in a $150 million market capitalization. You pay dividends of $3 million out of net income, and reinvest the rest into expansion. If there were 10 million shares outstanding, the numbers would look like this: $15 stock price, $1 basic earnings per share, and $0.30 per share dividends for a dividend yield of 2.0%.
When the economy tanked, your stock fell to a p/e of only 4x earnings, resulting in a market capitalization of only $40 million. Sometimes, there is a lag between Wall Street panics and when the result of a bad economy hits the books of a firm. In the aftermath of the fall, the numbers are going to look like this: $4 stock price, $1 basic earnings per share, $0.30 dividend, with a yield of 7.5%. In other words, it looks like you could park $100,000 in the stock and earn $7,500 per year in cash dividends, while waiting for the market to recover. Think of it as being paid for your patience.
The problem? It’s likely that SLJ’s sales and profits are going to be hit hard because no one wants to buy a diamond bracelet when they are about to lose their house. If profits were to fall by, say, 60%, earnings per share would be only $0.40 – not $1.00 like they were last year. That makes the $.30 dividend equal to 75% of the company’s annual profit. The Board of Directors might want to keep those liquid funds on hand to prepare for an even worse downturn to avoid layoffs or violating covenants on bank loans. The only way to fix it? You guessed right. Slash the dividend.
The immediate effect of a substantial dividend cut is likely to be an enormous drop in stock price. That’s because many investors are willing to wait for things to turn around if they are getting checks in the mail (or deposited into their brokerage account, as is more often the case). When that stream of cash dries up, they aren’t so patient.