Don't get caught in a yield trap. Learn how to use earnings per share (EPS) and payout ratios to assess the safety of your dividend income.
High dividend yields can be tempting. Who doesn't want a 10% return on their investment just from cash flow? But as experienced investors know, a high yield can often be a warning sign rather than a bargain. This is what's known as a "yield trap" - a stock with a high dividend yield that is unsustainable and likely to be cut.
So, how do you distinguish between a great opportunity and a trap? The answer often lies in the company's earnings.
Dividends are paid out of a company's profits (earnings) or its free cash flow. If a company isn't generating enough profit to cover its dividend payments, it has two choices:
This is why analyzing earnings is crucial for dividend investors. You need to look beyond the yield and check if the underlying business is healthy enough to support that payout.
The payout ratio is the percentage of earnings paid out as dividends.
Payout Ratio = Dividends per Share / Earnings per Share (EPS)
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Are earnings growing, flat, or declining? A company with declining earnings will eventually struggle to increase - or even maintain - its dividend. Look for a history of consistent EPS growth.
This is also where EarnDivs shines. An "earnings surprise" happens when a company reports earnings that are significantly higher (or lower) than analysts expected.
Imagine Company A offers an 8% yield. It looks great on paper. But a quick check of its earnings shows:
This is a classic yield trap. The market has priced the stock low (driving the yield up) because it expects a dividend cut. By focusing solely on the 8% yield, an investor might walk right into a loss.
Dividend investing isn't just about collecting checks; it's about owning profitable businesses. By incorporating earnings analysis into your research - checking payout ratios, growth trends, and earnings surprises - you can build a portfolio that provides not just high income, but safe and growing income.
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