====== Dividend Trap ======
A Dividend Trap is a stock that lures investors with an exceptionally high [[dividend yield]], which often signals a company in deep trouble rather than a healthy investment. Think of it as the siren's call of the stock market; it sounds beautiful and promises easy riches, but it can lead an investor's portfolio straight onto the rocks. The trap is sprung when the company, facing financial distress, inevitably cuts or eliminates its dividend. This event almost always causes the stock price to plummet, leaving the investor with not only a loss of their expected income stream but also a significant capital loss. The very thing that made the stock look attractive—the high yield—was actually a warning sign of its underlying weakness and the impending financial pain.
===== The Allure of the High Yield =====
Investors are naturally drawn to high-yield stocks for a simple reason: they promise a high stream of passive income. The dividend yield is calculated as the company's annual dividend per share divided by its current stock price (Annual Dividend / Stock Price). This simple math reveals the heart of the trap. A juicy yield can be the result of a company generously increasing its dividend, which is great. However, it can also be the result of a collapsing stock price, which is a major red flag.
For example, if a company pays a $2 annual dividend and its stock is trading at $50, the yield is 4% ($2 / $50). If the market loses faith in the company and the stock price falls to $20, the yield mathematically skyrockets to 10% ($2 / $20). An unsuspecting investor might see that 10% yield and think they've found a bargain, when in reality, they are looking at a business whose market value has been more than halved. The high yield isn't a sign of strength; it's a symptom of a falling price.
===== Warning Signs of a Dividend Trap =====
A savvy investor, especially one following the principles of [[value investing]], knows to look under the hood before being tempted by a shiny yield. Here are the key warning signs to watch for:
==== The Payout Ratio Red Flag ====
The [[payout ratio]] measures what percentage of a company's earnings are being paid out as dividends. It's calculated as Dividends per Share / [[Earnings Per Share (EPS)]].
  * **Unsustainable Payouts:** A payout ratio consistently above 80%, or worse, over 100%, is a massive warning sign. If it's over 100%, the company is paying out more money to shareholders than it's actually earning. To do this, it must dip into its cash reserves, sell assets, or take on debt—none of which are sustainable in the long run.
  * **Industry Nuances:** Be aware that some sectors, like [[Real Estate Investment Trusts (REITs)]], are structured to pay out most of their income. For these, investors should look at the payout ratio relative to [[Funds From Operations (FFO)]] instead of EPS for a more accurate picture of dividend safety.
==== Dwindling Earnings and Cash Flow ====
A company's ability to pay a dividend comes directly from its ability to generate cash.
  * **Check the Trend:** Don't just look at a single quarter or year. Is the company's revenue and net income on a downward trend? If the business is shrinking, its ability to support the dividend is also shrinking.
  * **Cash is King:** Look beyond earnings to the statement of cash flows. A company must have positive [[free cash flow]] (the cash left over after operating and capital expenditures) to pay its dividend without borrowing. A healthy company will generate more than enough free cash flow to cover its dividend payments.
==== A Mountain of Debt ====
A company's [[balance sheet]] can tell you a lot about its financial resilience. A company with a huge debt load is fragile. When times get tough, debt holders get paid before shareholders. A high [[debt-to-equity ratio]] compared to industry peers can signal that in a downturn, cash will be diverted to service debt, putting the dividend on the chopping block first.
==== A Declining Industry ====
Sometimes the problem isn't just the company; it's the entire industry. A company in a sector facing structural decline (e.g., Blockbuster in the age of streaming) may fight valiantly, but the tide is against it. Even the best-run company in a dying industry will eventually face impossible choices, and the dividend is an easy expense to cut to conserve cash for survival.
===== A Value Investor's Perspective =====
For followers of [[Benjamin Graham]] and [[Warren Buffett]], a high dividend is never the sole reason to buy a stock. It can be a pleasant bonus, but it's secondary to the fundamental quality and valuation of the underlying business. The goal is not to chase yield; the goal is to buy a great business at a fair price.
A true value investor uses a high yield as a signal to start doing homework, not to start buying. They ask //why// the yield is so high. Is it a temporarily beaten-down, high-quality company that the market has misunderstood? Or is it a fundamentally flawed business heading for a cliff? The difference between a true bargain and a dividend trap lies in the sustainability of the business and its earnings. A fat dividend from a dying company is a poor substitute for the steady, growing dividends from a healthy one, all protected by a [[margin of safety]].