Yield traps: the five signals that a dividend is about to be cut

What you will learn

• What a yield trap is and why a very high yield is usually a warning, not a gift.
• Five signals you can check with published figures before the cut is announced.
• How these signals appeared in cuts by Kraft Heinz (2019), Shell (2020), Intel (2023) and Walgreens (2024).
• A scoring routine for any high-yield share.

Explanation

A yield trap is a share whose dividend yield looks attractive only because the share price has fallen in anticipation of a cut. The yield you see is based on the last dividend; the market is pricing the next one. When the cut comes, you lose the income and usually more share price.

The five signals below combine the payout ratios from lesson 2 with balance-sheet and business trends. One signal is a caution; three or more is a strong warning.

Signal 1 – yield far above its own history and its sector. More than roughly twice the share's five-year average yield or the sector median means the market doubts the payment.

Signal 2 – payout above 100 percent of free cash flow for two or more years. One bad year can be bridged with cash; two means the dividend is financed by borrowing or asset sales.

Signal 3 – rising leverage. Watch net debt / EBITDA (net debt divided by earnings before interest, tax, depreciation and amortisation). A rise from about 2× towards 3.5× for a non-utility, or a credit rating one notch above junk (BBB−), means the board will soon choose between the dividend and the rating, and boards almost always choose the rating.

Signal 4 – a frozen dividend after years of increases, with defensive language. A decade of increases followed by a flat dividend and statements that it is "fully committed" means the question has been asked internally.

Signal 5 – a shrinking or impaired business. Falling revenue, large goodwill write-downs, or asset sales needed to fund the dividend show declining earnings power; dividends follow with a lag.

Real cuts that showed these signals in advance. Kraft Heinz cut its dividend by 36 percent in February 2019 alongside a 15.4 billion dollar impairment of goodwill and brands, with around 31 billion dollars of bonds outstanding (signals 3 and 5). Shell cut its dividend by two-thirds in April 2020, its first cut since the Second World War, after the oil price collapse removed the cash flow that covered it (signals 1 and 2). Intel cut its dividend by roughly two-thirds in February 2023 after free cash flow turned negative during a heavy investment programme (signal 2), and later suspended it. Walgreens cut its quarterly dividend from 0.48 to 0.25 dollars in January 2024, its first cut in almost fifty years, after years of falling margins and a yield far above its history (signals 1 and 5). In each case the signs were in the published accounts months before the announcement.

Worked example

Hypothetical example: Telenord AG trades at €20 and paid €1.60 per share last year. Sector median yield is 3.5 percent. Fees and taxes are excluded.

Step 1 – yield check. €1.60 / €20 = 8.0 percent, which is 2.3 times the sector median. Signal 1 triggered.

Step 2 – payout check. EPS €1.50, so earnings payout = 1.60 / 1.50 = 107 percent. FCF = €420 million − €300 million capex = €120 million. Dividends paid = €1.60 × 150 million shares = €240 million. FCF payout = 240 / 120 = 200 percent; if last year was similar, signal 2 is triggered.

Step 3 – leverage. Net debt €1,800 million, EBITDA €600 million, so net debt / EBITDA = 3.0×, up from 1,500 / 700 = 2.1× the year before. Signal 3 triggered.

Step 4 – history and business. The dividend has been flat for three years after a decade of increases; revenue falls 4 percent a year. Signals 4 and 5 triggered.

Conclusion. Five of five signals. Expect a cut to a level FCF can support, perhaps €0.60 to €0.80 per share (3 to 4 percent on today's price), and a further price fall on the announcement.

Common mistake

Practice activity

On paper: Baltic Retail SE trades at €30, last dividend €2.40, sector median yield 3.0 percent. EPS €2.00. Cash flow from operations €500 million, capex €380 million, 100 million shares. Net debt €1,300 million, EBITDA €400 million. The dividend has been raised every year for 15 years. Revenue is flat. Score the five signals and give a verdict.

Key takeaways

• A yield far above sector and history usually means the market expects a cut.
• FCF payout above 100 percent for two years and rising net debt / EBITDA are the two strongest predictors.
• Frozen dividends with reassuring language, and shrinking or impaired businesses, complete the checklist.
• Score all five signals; three or more means plan for the cut before it happens.

Next step

Lesson 4 looks at the opposite end of the spectrum: dividend aristocrat and quality-dividend indices that try to screen out such companies, and the limits of their rules.