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When looking for dividend stocks, it’s tempting to gravitate towards securities with the highest yields. This is not always the smartest strategy; there’s more to a worthwhile dividend stock than just a high yield.

Sure, robust dividends are offered by well-known companies with solid balance sheets. But high dividends also can be used by new or inherently weak companies as bait for investors.

A “dividend trap” is when investors hungry for yield are suckered into a high dividend yield, only to eventually discover that the underlying company is deeply troubled. That’s when the dividend gets cut or eliminated and unsuspecting investors get stung.

Income-hungry investors have piled into high-yielding stocks without always subjecting them to critical analysis. Investment publications and websites tout all sorts of intriguing high yielders, ranging from business development companies and mortgage finance firms to tanker owners and energy plays.

Read This Story: Why the Payout Ratio Can Be Misleading

Stocks that pay sizable dividends can be compelling investments, and in many cases, they may even be relatively safe. However, the field of big yields requires careful analysis to avoid pitfalls.

A company that can’t fully support a high dividend is only one bad quarter away from being trampled by the market. The trick is to take a few simple steps to identify companies whose dividends are both attractive and sustainable.

Step 1: Determine if a company consistently earns enough to meet its dividend. Since earnings can be lumpy from quarter to quarter, it’s best to see whether a company’s full-year earnings consistently cover the payout, with sufficient money left over to finance future growth. If earnings fail to exceed the payout, the dividend probably isn’t sustainable and could be cut at the first sign of trouble.

Step 2: Look at the company’s payout ratio, or how much of its earnings are being paid out in dividends. That number is easily calculated by dividing the total dividends paid in any year by full-year earnings per share.

The result will give you a good idea of how far earnings can fall before the dividend would have to be cut. For instance, a company with a payout ratio of 60% could see its earnings fall by 40% before the dividend is in real danger.

What constitutes a healthy payout ratio depends on the industry, but on average, a good upper range is between 50% and 70%. A payout ratio much higher than that is an indication that the company isn’t investing in itself, thus stifling future growth potential as well as the prospect for an eventual increase in the payout.

A higher payout ratio also leaves a company little room for error in terms of earnings. One bad quarter could force it to borrow to cover the dividend or even resort to a dividend cut. If the payout ratio jumps above 100%, in most cases the company is either dipping into cash reserves or taking on debt in order to make its payout. In either case, that’s a red flag that the dividend is in danger of being cut.

Step 3: Look at the payment history. A consistent track record of maintaining the dividend in good times, as well as bad, indicates a dividend cut is unlikely. If a company has a long-term record of consecutive dividend increases, even though the boost in payout may have varied, it’s a strong indication that management is committed to returning cash to shareholders.

While there are additional measures required to fully evaluate a dividend-paying company, these few simple steps will help you avoid the worst of the dividend traps.

Knowing your risk tolerance will help you decide which investment strategy is right for you. For example, if you have a low risk tolerance, you may want to emphasize safe haven investments even though your time horizon indicates you could be more aggressive.

If you’re investing for income, your focus should always be on the health of the underlying business. The best dividend stocks are the ones that are in good shape and growing, so they can maintain and raise their payouts.

Editor’s Note: Are you looking for high yields, but you also want to mitigate risk? Consider my colleague, Nathan Slaughter, the chief investment strategist of High-Yield Investing.

For the last 16 years, Nathan has made it his solitary focus to help everyday Americans invest profitably for retirement.

As a high-yield expert, Nathan has devised a simple strategy that could help you continually generate a steady stream of income, almost like clockwork. Click here for details.

John Persinos is the editorial director of Investing Daily.

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