Q: There's a stock I have my eye on that pays a 10% dividend yield. This sounds too good to be true. Is it?
Generally speaking, double-digit dividend yields are indeed too good to be true. They are often either being paid by unstable companies, or simply represent too much of a company's earnings to be sustainable.
Of course, there are some exceptions. There are a few questions you should ask yourself to help you avoid dividend yield traps, which is a common term for stocks with too-good-to-be-true dividends. I'll use two stocks as examples to illustrate them.
For starters, does the stock pay an unusually high dividend for its industry? Most telecom stocks have yields around 5%, so CenturyLink's11% yield should certainly set off alarm bells. However, senior housing REITs tend to pay 6% to 7% right now, so Senior Housing Property Trust's8% yield isn't necessarily out of the ordinary.
Next, does the payout represent an excessive percentage of a company's net income? Senior Housing Property Trust pays out about 86% of its funds from operations -- a completely normal payout for a REIT. Meanwhile, CenturyLink pays out more than 135% of its trailing-12-month earnings, a potential red flag.
Finally, are there problems with the business from a long-term perspective? For example, some forms of brick-and-mortar retail are having trouble adapting to the e-commerce surge, so 10%-yielding DDR Corp, an owner of shopping centers, could have a tough time maintaining its payout. On the other hand, senior housing is a growing market, so Senior Housing Properties Trust doesn't have a similar long-term trend working against it.
To be clear, these are just a few examples of things to look for and aren't reasons to buy (or not buy) the stocks mentioned here. However, they can give you an idea if a stock's dividend could be in trouble.
Matthew Frankel has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
