The Dividend Trap

A dividend trap is where a stat is published stating the dividend return of a company, where that stat is incorrectly used to derive value in a stock.

For example, if a company pays out 50% of it’s earnings as a dividend each year, which equates to 5% of the current share price, one might assume that they get 5% Return On their Investment (ROI). However, if the company has a bad outlook for coming years, resulting in a drop in future earnings, the future dividend may only be 1% of the current share price, giving a 1% ROI.

Tip: A downward trending share price might give a clue that there is a dividend trap!

Lewis Hurst

Similarly a dividend trap can occur if an investor assumes that dividends are being paid from earnings, but actually the dividend is coming from the sale of subsidiaries, large assets (such as stock, in the case of an ETF), or debt – which makes future dividend payments of that size unsustainable.

Moral of the story: Don’t buy stocks based on the dividend without looking into the finances and company outlook.

Addendum: I’ve noticed that Google can also be incorrect in the dividend yield when you search for a stock, so be careful there, too.

Additionally, you may have to consider the tax implications of dividend yields. For example, if you buy a stock on the ASX, that company may have fully franked dividends, but if you live in NZ you may be paying tax in addition to that.