Snap-On

US8330341012

SNA

SNA

Dividend cuts are the worst. 👎

Unfortunately, I've experienced a couple of them over these last few years, though thankfully none as bad as what V.F. Corporation ($VFC (-3,63 %)) has been shelling out this year (two cuts in 2023 - the first by 41% and then, more recently, by 70%).

If you plan on investing for any extended amount of time, you're likely to experience at least one of them yourself. Sometimes they come out of nowhere, and there's just nothing you can do, but one way that you can take extra precautions against dividend cuts is to pay extra attention to the Payout Ratio - a good litmus test for a company's ability to sustain and even grow its dividend payments.

The Payout Ratio represents the percentage of a company's earnings that it chooses to distribute as dividends. The lower this ratio, the more reassuring it is for us as investors.

A low Payout Ratio indicates that a company is not overextending itself to pay dividends, and implies that it'll have an easier time sustaining and even growing those payouts over time.

A prime example of this is Snap-On ($SNA) (+1,54 %), one of the 10 stocks in "My Perfect Portfolio." Snap-On's Payout Ratio is only 35%, meaning they retain the majority of their earnings to reinvest in their business or save for a rainy day.

Such a conservative approach in the dividend department gives us some insight into the company's financial prudence, and sets the stage for the possibility of future dividend growth (which SNA has done a great job with so far with their 14% Dividend Growth Rate).

However, not all companies are like Snap-On. Take Leggett and Platt ($LEG (+2,53 %)) for instance, which is sporting a Payout Ratio near 120% and is currently paying out more in dividends than it's earning.

Yes, $LEG (+2,53 %) has a 7.8% dividend yield, and that might have you seeing dollar signs, but this scenario is far from sustainable. We'll see what happens, but this may be the makings of a certified "Yield Trap".

A yield trap may lure you in with its temptingly high dividend yield, but it's a short-lived attraction. Continuing to pay out more than you earn is a path that ultimately leads to dividend cuts, and it's crucial to see beyond the yield and focus on the sustainability of those payments.

With that said, I want to hear from you: Do you know of any yield traps that we should stay away from? Let me know in the comments below! 👇