If you’re investing for income, you should watch out for the high-yield “trap”.
This trap involves investing in stocks only because they have high dividend yields.
Certain stocks may have high yields because their businesses are in trouble, which could result in lower dividends over time.
There are a number of things to look out for in a stock so that we can minimise – but not completely eliminate – the chances of us falling into a high-yield trap.
Firstly, we should analyze a company’s dividend history, going back at least a few years.
What we need to see is if the company has been consistent in terms of paying a dividend.
Secondly, we should also examine the payout ratio of a stock. The payout ratio represents the proportion of net profit that is paid out as a dividend.
Generally, a payout ratio that is close to or over 100% is a red flag – it’s hard for a company to continue paying a dividend that’s higher than what it’s earning.
A good range would be for a company to pay out anywhere between 40% and 75% of its earnings.
Thirdly, we could look at the balance sheet of a company. A company that has too much debt is putting its dividend at risk.
A good rule of thumb to sieve out a healthy balance sheet is to look for a company with debt that is less than 100% of its equity.
Stay tuned next week where we provide examples of stocks that pay out dividends.
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