Yield Trap
Quick definition: A yield trap is a stock whose dividend yield looks attractive only because its share price has fallen, and whose dividend is likely to be cut.
In plain English
Yield rises when the price falls. A company in trouble can therefore show a high yield, which attracts investors just before the dividend is cut. That is the trap.
Example
A stock pays $2 a year and trades at $50, a 4% yield. Bad news pushes the price to $25 and the yield jumps to 8%. It looks like a bargain, but the market is signalling that the dividend may not last.
How to check
- Is the payout ratio above what is normal for the industry?
- Is free cash flow covering the dividend?
- Is debt rising?
- Has earnings or revenue been falling?
Common mistakes
- Sorting a list by yield and buying the top names.
- Ignoring why the price fell.
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