Reading dividends right – and spotting dividend traps
A high dividend yield looks tempting, but is often a warning sign. It usually does not arise because the dividend went up, but because the share price went down – often because the market expects a cut. What matters is not how high the dividend is, but whether the company earns it.
What the dividend yield measures
If a company pays a €4 dividend and the share costs €100, the yield is 4%. That sounds simple. The catch is in the denominator: the yield rises not only when the dividend rises, but also when the price falls.
How a dividend trap arises
A made-up company has paid €4 per share for years. Then business gets worse and the share price halves. What happens to the yield:
| Situation | Dividend · price | Yield |
|---|---|---|
| Before | €4 · €100 | 4% |
| Price halves | €4 · €50 | 8% |
| Dividend cut | €2 · €50 | 4% |
At 8% the share looks like a bargain. Anyone who buys now because the yield is so high often experiences the cut shortly afterwards – and ends up with 4% on a share that has already lost half its value. That is the trap: the high number does not show the future, it shows the problem.
Four questions before you trust the yield
How to recognise a good dividend
A healthy dividend is usually not the highest but the most reliable: it is well covered by profit and free cash flow, it has risen over many years and was not cut even in weak years, and the company did not keep taking on more debt along the way. A 3% yield that grows every year often brings more over the long run than 8% that is halved next year.
How to turn a reliably growing dividend into a fair value is shown in the article The dividend discount model.
Three common mistakes
See the dividend next to the money that pays it.
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Frequently asked questions
At what yield should I become suspicious?
There is no fixed limit. A good guide is comparison: if the yield is clearly above that of similar companies and above its own history, the coverage deserves a closer look.
What payout ratio is healthy?
It depends on the business. Stable companies such as utilities can pay out more than cyclical ones. What matters is that profit and free cash flow cover the dividend safely over many years.
Is a dividend cut always bad?
Not always. Sometimes it is a sensible decision to pay down debt or invest in the future. It is mainly bad when it comes as a surprise because you overlooked the warning signs.
Does this also apply to REITs?
Yes, with one difference: for REITs you check coverage not against profit but against FFO. More on this in the article How to value REITs.
Not investment advice. All content is for informational and educational purposes only. The company in the example is made up.