These 6 Stocks Are Safer Than You Think

Dividend investors have had a tough time lately.

With more than a thousand stocks boasting dividend yields of more than 5%, you'd think that dividend seekers would be in seventh heaven. But unfortunately, you haven't been able to count on those dividends for the long run. Hundreds of companies, including big ones like US Bancorp (NYSE:USB), have cut their dividends this year, while the number of companies raising their payouts has reached a record low.

Right now, many companies seem to be paying dividends at unsustainable rates. But before you conclude that you're sitting on a dividend trap, take a closer look and see whether you're basing your opinion on a one-time aberration.

Some flaws of the payout ratio
In trying to determine whether a company will be able to afford paying its dividends in the future, you can look at its payout ratio. The payout ratio compares how much money a company brings in through earnings with how much it's paying out in dividends.

Ideally, payout ratios should be relatively low, giving a company enough income not only to meet its dividend obligations, but also to leave some extra for capital spending, new business projects, or strategic acquisitions. When a company's dividends exceed its earnings, it's often considered a sign that the dividend is doomed to be cut in the near future.

The problem with relying strictly on the payout ratio, however, is that it only represents a snapshot in time. And right now, with earnings depressed because of the recession, payout ratios aren't necessarily giving you a realistic picture of a company's long-term outlook.

Banking on a recovery
For example, take a look at these companies and their current payout ratios:

Source: Yahoo! Finance.

As you can see, all of these companies have payout ratios well in excess of 100%, suggesting an impending problem in maintaining their current dividend levels.

However, those earnings figures are in most cases well below expectations for what these companies will earn next year. Here are the figures:

Source: Yahoo! Finance.

Looking forward, you get a somewhat different picture. Many of these companies won't be out of the woods even if things go as well as expected, but their dividends look a bit healthier than they do today.

To avoid being misled by turbulent earnings changes from year to year, some investors look at payout ratios based on free cash flow rather than earnings. Yet no matter which measure you look at, you should be aware that while tough economic conditions can push a company into the danger zone for a while, that doesn't necessarily mean that its long-term prospects are doomed.

Whatever it takes
It certainly isn't ideal for companies to ever dip into cash reserves to cover dividend payments. But as long as it's strictly a temporary measure, most companies can afford to do so -- and it's probably good for them to keep making their payouts, if only to avoid the loss of reputation and share value that often comes from cutting dividends.

During rocky times for the markets, investors often panic at the slightest hint of bad news. Yet while metrics like the payout ratio can be quite helpful in analyzing dividend stocks, bear in mind that they don't always work perfectly under extreme conditions. If you keep your eyes open to possible inconsistencies, you'll feel more comfortable sticking with dividend stocks that have excellent long-term potential.

Even after the rally, you can find attractive stocks with amazing dividend yields. Find out which ones you should grab before it's too late in this article from Adam Wiederman.