1. Money
You can opt-out at any time. Please refer to our privacy policy for contact information.

Watch Out for the Dividend Trap

When High Dividend Yields and Low P/E Ratios Are An Illusion

By

Dividend Trap

Sometimes, you find a stock that appears to offer huge cash dividends with a dividend yield several times the rate available at your local bank. Take a moment, calm down, and proceed with extreme caution. You may have just spotted a dividend trap.

Jeffrey Coolidge, Getty Images
Right now, a glance across the stock tables shows companies trading at 3-4x earnings with nearly 10% dividend yields – or more than twice the funding cost of a 30-year fixed rate mortgage. That sort of value situation hasn’t existed since the horrific crash of the 1970’s, yet that doesn’t mean you should go out and start buying everything you can get your hands on, especially if you are vulnerable to job loss or don’t have excess cash on hand for emergencies. Yes, there are tremendous values. Yes, at my companies, we have taken advantage of the situation by expanding the operating businesses and using excess cash flow to buy stocks. However, we are fully aware that there is a very real potential for what is known as the dividend trap.

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.

©2014 About.com. All rights reserved.