A bear market is generally defined as a drop of at least 20% from recent highs, and unfortunately, that’s been the case for a lot of great companies and major stock indexes. While bear markets can present good opportunities for investors, they can also be prime territory for dividend traps.
A dividend trap is a dividend yield that’s too good to be true. These stocks lure investors in with a high yield that turns out to be unsustainable or a bad overall investment. Dividend traps may not be obvious initially, but here’s what you could look for to avoid them.
Look past the dividend yield
When companies set their annual dividends, they do so in a per-share dollar amount. For example, Coca-Cola‘s (KO 0.82%) dividend for 2022 was set at $1.76 per share ($0.44 paid quarterly). Since the dividend is a set amount, the dividend yield fluctuates with a stock’s price.
If a company pays out $2 in annual dividends and its stock price is $100, its dividend yield would be 2%. If the stock price dropped to $80, the dividend yield would now be 2.5%. By strictly looking at the dividend yield, investors can make the mistake of seeing an increased dividend yield as a good thing without considering why the dividend yield increased.
During bear markets, this increased dividend yield could just be a byproduct of lower stock prices across the stock market as a whole. Or a company’s stock could be plummeting because something is changing within its business, and its future isn’t looking so bright. Whatever the case, you always want to know what it is, so you’re not making uninformed investing decisions.
Look at the payout ratio
One underrated metric for spotting dividend traps is a company’s dividend payout ratio, which tells you how much of its earnings it’s paying out in dividends. You can calculate the dividend payout ratio by dividing a company’s yearly dividend by its earnings per share (EPS). You can find these numbers when looking at a stock on your brokerage platform or its financial statements.
If a company’s payout ratio is more than 100%, it’s paying out more in dividends than it’s earning, which is a red flag. At some point, a company can’t keep paying out more than it’s bringing in. Either the dividend will need to be cut, or the company will run out of money — neither of which is good for investors focused on dividends.
There isn’t a dividend payout ratio universally considered “good” because dividend best practices vary by industry, but in general, you probably want a ratio between roughly 30% and 50%. Less than that, and the company may not be as shareholder-friendly as you’d prefer (though there’s more room to increase the dividend). More than that, and the dividend may be unsustainable, or the company isn’t reinvesting enough money back into the business.
You can’t forget about debt
Before you invest in a company, it’s always helpful to know how much debt it has. There’s nothing wrong with a company having debt. Sometimes, it can actually make sense for a company to take on debt because the return on investment will be higher than the interest owed on it. However, with debt comes risk, and at some point, too much debt becomes a no-no — especially if a company is using the debt to pay out its dividends.
A company’s debt-to-equity ratio lets you know how much of its business is being run on debt, and you can find it by dividing its total debt by shareholder equity (both found on a company’s balance sheet). Like payout ratios, debt-to-equity ratios vary widely by industry. For example, businesses in industries like manufacturing often have higher ratios, while technology businesses often have lower ratios.
Investors should be cautious of companies whose debt-to-equity ratio is higher than 5:1, because that means a large part of their business is funded by debt.
Do your homework
There are many great stocks trading at a discount because of the bear market. If you have the financial means, now can be the time to double down and ramp up your investing, but it’s always important to remember that everything that glitters isn’t gold. You still want to do your due diligence and make sure you’re not investing in a company just because of its high dividend yield.
Stefon Walters has no position in any of the stocks mentioned. The Motley Fool recommends the following options: long January 2024 $47.50 calls on Coca-Cola. The Motley Fool has a disclosure policy.
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