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 Finland's Nokia (NYSE: NOK), which only began paying a dividend in 2001.
No, we're talking companies with long dividend histories -- like BB&T (NYSE: BBT) and Toyota Motor (NYSE: TM), both of which recently slashed their dividends to free up capital. Others, like Eastman Kodak (NYSE: EK), 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 company's financial position. The company might go under -- or, more likely, it could cut its dividend, thereby reducing the yield you thought you had paid for. One could argue that this is the case at GSC Investment (NYSE: GNV), an investment firm that currently yields a whopping 29.8%.
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 its 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
|
|
Best Buy (NYSE: BBY)
|
$14.7 billion
|
1.6%
|
178%
|
|
Staples (Nasdaq: SPLS)
|
$14.3 billion
|
1.7%
|
609%
|
Data from Capital IQ, a division of Standard & Poor's.
Best Buy, one of the nation's largest electronics retailers, could continue to face difficulty until consumers start to spend in force again, which could take years. And as Staples' most recent quarter made clear, offices have put big-ticket purchases on hold, and there's no sign this trend will reverse itself.
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. 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.
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This article was first published Feb. 28, 2009. It has been updated.
Adam J. Wiederman
doesn't own shares of any company mentioned above, though The Motley Fool owns shares of Best Buy. Best Buy and Staples are Stock Advisor recommendations. Best Buy and Nokia are Inside Value recommendations. The Motley Fool has a disclosure policy.
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