Can You Count on Your Dividends?

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Got dividends? Probably not as much as you previously thought.

The Associated Press recently reported that dividends "are being cut at the fastest pace in at least 50 years." What's more, the cutters aren't just dividend upstarts like Brazil's Petrobras (NYSE: PBR); in accordance with a recent court decision, the oil company suspended the dividend it began paying in 2001.

No, we're talking companies with long dividend histories -- like The Bank of New York Mellon (NYSE: BK) and Morgan Stanley (NYSE: MS), both of which recently slashed their dividends to free up capital. Others, like BorgWarner (NYSE: BWA), have suspended their quarterly dividends altogether.

It's not easy being a dividend
All told, as my Foolish colleague Ilan Moscovitz notes, companies eliminated a mind-boggling $22 billion in dividend payments during the third quarter of 2008 alone. This is especially distressing because it's estimated that more than half of America's retirees rely on dividend income to maintain their standard of living. Was there any way investors could see this coming?

Perhaps. Not every dividend cut mentioned above was expected, but many companies gave signs -- or are giving signs -- that a savvy investor could have spotted.

High expectations
It's important to remember that while the market is often irrational, it isn't always so.

As such, a high yield often indicates underlying troubles, because it signals that shares have been beaten down to such an extent that investors have serious doubts about the firm's financial position. The company might go under -- or, more likely, it could cut its dividend, thereby reducing the yield you thought you paid for. One could argue that this is the case at Apartment Investment & Management (NYSE: AIV), a real estate investment manager that currently yields a whopping 90%.

Bottom line: Investments in stocks with yields of more than 20% are better left to speculators.

High payouts
But even low-yielding companies can face a dividend cut. Perhaps the best way to assess both the near-term and long-term feasibility of a company's dividend is to determine the company's dividend payout-to-free cash flow ratio. This metric pits a company's annual dividend outflows against its annual free cash, i.e. the uncommitted cash a company has remaining after maintaining its current operations and investing in future business.

Companies have a very difficult time supporting free-cash-flow payout ratios greater than 100%, because the only way to pay out more cash than they earn is to issue shares, issue debt, sell off assets, or deplete cash reserves -- none of which are sustainable over the long term.

By way of example, here are two such companies whose dividends might soon go the way of the dodo (or Grant Williams), as evidenced by this ratio:

Company	Market Cap	Dividend Yield	Levered Free Cash Flow Payout Ratio
Cohen & Steers (NYSE: CNS)	$625 million	1.3%	204%
World Wrestling Entertainment (NYSE: WWE)	$774 million	13.6%	656%

Data from Capital IQ, a division of Standard & Poor's.

Cohen & Steers, an investment manager, faces difficult headwinds, and the fees it collects for managing clients' wealth will continue to dry up if global markets remain rocky. World Wrestling Entertainment, which makes the bulk of its revenue from live and televised events, could have difficulty convincing its core demographic of young males to cough up $40 for just three hours of entertainment, especially if the economy continues to worsen.

Dividend defense
I certainly don't mean to argue that you should forsake dividends altogether; in fact, I think now is an opportune time to pick up solid dividend-paying companies. But it's extremely important to remain on the defensive against companies that are spending more on dividends than they can realistically afford, especially given our economy's current environment. The stakes have changed.

In a market increasingly hostile to dividends, our Motley Fool Income Investor team, led by former hedge fund analyst James Early, is assessing the strength and sustainability of Wall Street's top dividend-paying companies. You can see the team's top recommendations completely free for the next 30 days. Click here for more information.

This article was first published Feb. 28, 2009. It has been updated.

Adam J. Wiederman owns shares of no company mentioned above. BorgWarner is a Motley Fool Stock Advisor recommendation. Petrobras is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.