Seven Dividend Warning Signs to Watch Out For

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Although the futures market is pricing in the possibility of the Federal Reserve announcing up to four rate hikes this year, bond yields remain low. The continued low-interest-rate environment makes reaching for higher-yielding dividend stocks seem like a potential option.

Investors would be prudent to watch where they step. Just as you shouldn’t judge a book by its cover, neither should you judge a stock solely by its yield. High yields reflect perceptions of higher risks. The upside of a few percentage points of yield can easily be offset by a decline in the stock’s price. 

One way to avoid such dividend traps is to weed out the riskiest stocks. My colleague Derek Hageman says there are dividend warning signs to watch out for.

They include:

1. Excessively high dividend yields—This occurs when investors demand higher compensation for perceived greater risk.

2. A previous or an expected decline in earnings—This impacts both the valuation and the ability to grow the dividend.

3. An excessively high payout ratio—Payout ratios in excess of 100% are not sustainable.

4. Declines in cash flow—Falling levels of cash can jeopardize the dividend.

The three additional dividend warning signs Derek thinks investors should watch out for are:

5. Dividends exceeding earnings—Dividends higher than reported annual earnings are a warning sign since this level of payment cannot be sustained over long time periods. Derek evaluates dividend coverage metrics such as the earnings payout ratio (dividends per share divided by earnings per share) as part of our Dividend Investing newsletter. (DI is included in AAII Platinum.) He also looks at the free-cash-flow payout ratio (percentage of free cash flow per share paid out as dividends).

6. Too much debt—Heavier debt loads saddle a company with required cash outflows to bondholders, who must be paid before dividends can be paid to shareholders. Since too much leverage strains the company’s ability to pay the debt back, creditors and dividend investors prefer companies with moderate debt levels. More assets relative to debt cushions a company during negative cash flow periods and should allow the company to maintain its dividend payment even during tough times. Some of the characteristics Derek evaluates are debt, liquidity and interest coverage ratios.

7. Deteriorating long-term trends—You can spot trends by examining all of the ratios and indicators mentioned above—as well as earnings, cash flow and revenues—on a year-by-year basis over the last five or 10 years, looking for positive values or values that are at least within acceptable ranges. Deteriorating values are a warning sign.

None of this is to say that all high-dividend-yielding stocks are bad. There will always be some that are bargains due to an industry slump, short-term company headwinds or negative sentiment. The key is to do your research rather than selecting dividend stocks by yield alone.