Dividend Trap Check (Explained Simply)

🧩 What It Means:

A dividend trap happens when a company continues paying high dividends even though it doesn’t have enough real cash to support those payments.

It might look good on paper — like a 12% dividend yield — but if the company is borrowing money or selling assets just to pay dividends, it’s a warning sign. It means the payout may not last for long.

📘 Step-by-Step Understanding


1️⃣ What to Compare

You need to look at two things side by side:

  • 💰 Free Cash Flow (FCF): The real cash left after the company runs its daily business and maintains its assets.
  • 🪙 Dividends Paid: The total cash the company gives to shareholders.

If dividends paid are more than FCF, it means the company is paying out more than it actually earns — a clear red flag 🚨.

📊 Understanding FCF (in simple terms)

Formula: FCF = Operating Cash Flow – Capital Expenditure (CapEx)

Operating Cash Flow = the cash a company gets from its normal business activities (e.g., selling products or providing services).

Capital Expenditure (CapEx) = money spent to repair, upgrade, or buy long-term assets like machines, vehicles, or systems.

Once the company spends what it needs to keep running (CapEx), the leftover cash is Free Cash Flow — that’s the real money available to:

  • Pay dividends 💵
  • Reduce loans 🏦
  • Expand the business 🚀

🧮 Example

Item Amount (KES Millions)
Operating Cash Flow500
Capital Expenditure300
Dividends Paid250

✅ FCF = 500 – 300 = 200

But since the company paid 250M in dividends, that’s KES 50M more than its available free cash — meaning it’s using borrowed or extra funds to pay dividends. That’s a classic dividend trap ⚠️.

⚠️ How It Affects You

  • ❌ Dividends may be cut or delayed in future.
  • 💔 The share price can fall once investors realize the dividend is not sustainable.
  • ⚠️ The company might borrow more to cover payments — increasing its debt.
  • 🧊 Less cash remains for growth or reinvestment.

You may enjoy the short-term dividend, but you could lose value when the share price drops.

✅ Healthy Dividend Policy (The Right Way)

A solid company pays dividends only from its real cash flows — not borrowed money.

As a rule of thumb: dividends should not exceed 70% of Free Cash Flow (FCF). This ensures the company still has enough cash left to grow and stay stable over time.

📌 Quick Tip: Before buying a “high dividend” stock, check if its FCF comfortably covers dividends. If not — that “sweet” yield could be a trap.

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