Many dividend stocks had great runs over the past year thanks to low interest rates pulling investors away from bonds and toward income stocks. But with interest rates expected to rise and many income stocks trading at premium valuations to the S&P 500, investors should recognize dividend traps with unsustainable payout ratios.
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A stock's payout ratio, looking at how much it pays out to shareholders in dividends, is calculated in one of two ways -- as a percentage of its earnings per share or as a percentage of its free cash flow. If either percentage exceeds 100%, it's losing money with those payments and could reduce its dividend.
In previous articles, I identified dangerous dividend stocks like Western Digital (NASDAQ: WDC), Frontier Communications, Guess, and Nokia. Today, I'll add two more stocks to that list -- Computer Programs and Systems (NASDAQ: CPSI) and NVE Corporation (NASDAQ: NVEC).
Computer Programs and Systems
At its current stock price and current dividend, healthcare IT company Computer Programs and Systems offers a dividend yield of 4%. But the dividend has been dropping since the summer, when the company approved a more conservative dividend policy. Its first two dividend payments in 2016 were $0.64 per share, but that payment was cut to $0.34 and then $0.24.
Computer Programs and Systems in August announced plans to pay a variable dividend limited to 70% of the preceding quarter's non-GAAP EPS. "Our Board elected to adopt a dividend policy that provides the Company the flexibility to pay off debt more quickly and to increase our investment in new solutions across all of the CPSI companies," the company said in an announcement.
The board's decision to base dividend payments on adjusted earnings doesn't bode well for future dividend payments, since analysts expect the company's non-GAAP earnings to fall4% this year due to acquisitions and tough competition in the healthcare IT space. Its cash position also fell from nearly $25 million at the end of 2015 to just $3.7 million at the end of September, and its long-term debt hit $150.6 million. That was due to the company making numerous acquisitions to bolster its revenue, which is expected to rise 47% this year. While that top-line growth looks encouraging after the stock's 50% decline in 2016, Computer Programs and Systems definitely doesn't offer reliable dividend growth for long-term income investors.
NVE Corporation manufactures tiny "spintronics" devices that use electron spins to acquire, store, and transmit information. The technology, which was discovered and initially developed in the 1980s, is used for random access memory applications in the industrial, scientific, and medical sectors.
NVE's growth has been dismal. It posted five straight quarters of annual revenue declines before eking out 0.3% sales growth last quarter. Looking ahead, thesingle analyst who covers NVE expects its revenue to rise 4% next year on warmer demand for its devices across multiple industries. Earnings are also expected to rise 3% next year.
However, NVE's forward dividend yield of 6% doesn't look sustainable. NVE only started paying a dividend last year -- with a special dividend of$2.06 followed by quarterly dividends payments of $1. Those dividend payments gobbled up 164% of its free cash flow and 167% of its earnings per share over the past 12 months. There's no way that those payout ratios can drop below 100% if NVE only grows its earnings by 3% next year. Furthermore, NVE stock's 20% rally in 2016 -- which boosted its trailing P/E to 28 -- seems partially fueled by investors seeking yield in a low-interest-rate environment. This means that a dividend cut could send shares sliding very quickly.
The key takeaway
With the market near historic highs and interest rates set to rise, income investors should stick with reliable dividend stocks with low multiples, sustainable payout ratios, and robust earnings growth. Simply screening for high yields could lead you to high-yield traps like Computer Programs and Systems and NVE, which could both slash their hefty payouts in the near future.
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Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of Western Digital. The Motley Fool recommends Guess?. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.