Some investors see a company's decision to initiate dividend payments as an automatic signal to buy shares. The rationale is that dividend-paying stocks are inherently less risky and dividend payments show management's confidence in the firm's financial strength and future growth prospects. After all, why initiate dividend payments if management isn't confident in the company's ability to pay them?
But these assumptions can be dangerous and can lure investors right into a dividend trap. Let me explain...

Unlike bond coupons, dividends aren't guaranteed. So if the company's cash flow is erratic, then the dividend may not be sustainable. In the worst-case scenario, investors are left with no dividend and a collapsing stock price.

The good news is that investors can usually avoid dividend traps with a little due diligence. Here are the warning signs I look for when evaluating whether a new dividend-paying stock is a potential Steady Eddie or dividend trap.

1. Excessive payout ratio

The first metric I use to assess a dividend stock is the payout ratio. High payout is the norm in certain industries where demand and cash flow are highly predictable such as utilities, telecommunications and real estate investment trusts (REITs). But I approach with caution any stock paying out more than two-thirds of earnings as dividends. That's because a very high payout leaves precious little margin for safety if the company's earnings deteriorate. Also, if the dividend consumes the majority of cash flow, then the company has less to reinvest in future growth.

Excessive payout finally caught up with beauty products marketer Avon Products (NYSE: AVP) this year. Avon had been growing its dividend 10% a year, but in recent years, rising payout rather than improvements in earnings has been the main driver of dividend growth.

At first glance, Avon's 4.5% dividend yield once looked like an attractive income opportunity. But a closer look at Avon's profit trends and dividend payout painted a less rosy picture. Avon continued to raise the dividend, despite a 42% decline in profits within five years. As a result, payout climbed from 50% to more than 80% of earnings. Because of the need to plow nearly all of cash flow back into the dividend, Avon couldn't reinvest enough in its business.

Avon finally hit a wall earlier this month when an 80% drop in third-quarter profits and weaker sales forced a 74% cut in the dividend. The company says this will provide financial flexibility as it undertakes a turnaround plan. Because of this, Avon's yield has dropped to a meager 1.7% while shares have lost 11% of their value.



2. Weak balance sheet

A high debt load on a company's balance sheet can be a big red flag for the dividend. Debt often comes with covenants that restrict the company's ability to pay dividends, with interest and principle payments limiting financial choices, which sometimes force managers to postpone share repurchases or acquisitions.

An example is Warner Chilcott (Nasdaq: WCRX), a mid-sized pharmaceutical company that recently began paying a dividend. Warner looks great at first blush. The company is highly profitable with 34% operating margins and free cash flow (cash flow after capital expenditures) averaging 140% of earnings. In the past two years, Warner has paid special dividends totaling $12.50 a share to shareholders and the company initiated a semi-annual dividend of 25 cents a share in August that yields about 4%.

But a closer look raises big concerns about Warner's financial health and growth potential. The company recently lost patent exclusivity in Europe on a major osteoporosis drug, Actonel, resulting in a 30% sales decline run rate so far this year. In addition, Warner has a risky balance sheet, showing $3.5 billion of debt versus only $530 million of cash. Even worse, Warner recently borrowed $600 million to pay a special dividend of $4 per share, which puts total debt above $4 billion. Borrowing to pay a dividend is a hugely risky business practice, yet the company has done this twice in three years.

The reason Warner paid the special dividend was to keep private-equity investors happy. But these firms recently cut their holdings, making it unlikely more special dividends will be paid anytime soon. In the meantime, remaining shareholders are left footing the bill and Warner's share price has declined 32%.



3. High stock beta

Another metric I use to assess a new-dividend stock is the "beta," which measures the price swings of an individual stock relative to the broad market. A high-beta stock is prone to wider price swings, while a low-beta stock is less volatile. Low-beta stocks can also decline in price, but high-beta stocks are far more likely to turn into a dividend trap.

A case in point is Questcor Pharmaceuticals Inc. (Nasdaq: QCOR), a drug company that began paying a dividend in November. Questcor's roughly 3% dividend yield looks attractive, but the stock's beta of 1.4 suggests hidden risks.

Questcor's earnings look great, up a staggering 181% in the first nine months of 2012 compared with the year-ago period, while the balance sheet is pristine with zero long-term debt. A closer look, however, reveals big concerns. A major worry is that Questcor derives nearly all of its sales from a single product -- Acthar Gel, which is used to treat many different skin conditions from lupus to psoriasis to allergies -- and has nothing else in the pipeline. In addition, health insurance giant Aetna recently said it will no longer be reimbursing for Acthar in some applications. Other health insurers may follow suit. Add in an ongoing government investigation into Questcor's marketing practices and it's no mystery why Questcor has been the most volatile stock in the S&P 500 for two months in a row, with an average intraday trading range of 9.3%.

Despite a nice dividend, this level of volatility makes Questor too risky to be considered an income investment.

Action to Take --> Avon has potential as a turnaround stock. Warner Chilcott and Questcor may appeal to growth investors who can tolerate risk. While their yields are attractive, Warner and Questcor have characteristics of dividend traps that make them unsuitable as pure dividend investments. If your goal is to invest in income-oriented stocks, then make sure your picks don't sport the three red flags I mentioned here.

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