These Dividends Are Crazy!

Great dividend stocks are an investor's best friend. But if a company's just fudging the numbers to make a juicy payout, should you really bet your life savings on it?

Why dividend stocks rule
It's easy to understand why smart investors look closely at stocks that have a long history of paying stable, growing dividends. The best dividend stocks have all the hallmarks that investors look for in an investment:

  • Profits. Companies that don't earn money can't afford to pay dividends. Most companies won't pay a dividend until they reach profitability and gain confidence that they'll stay profitable for the long haul.
  • Growth. Similarly, companies that are able to raise their dividend payouts consistently over time have to find ways to grow their core business to generate ever-increasing profits.
  • Commitment to shareholders. Other methods of using excess capital, such as stock buybacks, can often benefit option-holding executives as much as, or more than, ordinary shareholders. Dividends, on the other hand, go straight to shareholders, raising no worries about whether company insiders get unfair advantages.

These days, some yields are so high that they look too good to be true. One way to get a sense of whether a company's dividend payments are sustainable is to look at its payout ratio -- how big the dividends are compared to the company's earnings.

I expected that the most popular dividend stocks would have favorable payout ratios to support their current dividends and future payout growth. Yet when I looked more closely, I found a surprising number of dividend stocks that consistently pay more in dividends than they earn. Here are some of the biggest stocks that had payout ratios above 100% in each of the past five years:

Stock

Payout Ratio, 
Past 12 Months

Average Payout Ratio, 
Past 5 Years

Frontier Communications (NYSE: FTR  ) 233% 168%
Nordic American Tanker (NYSE: NAT  ) 4,700% 1,080%
Realty Income (NYSE: O  ) 157% 140%
Simon Property Group (NYSE: SPG  ) 115% 144%
Vector Group (NYSE: VGR  ) 190% 224%

Source: Capital IQ, a division of Standard & Poor's.

Some of those figures look positively astounding. It's easy to understand how a company can survive a year or two of oversized dividend payouts. Both Annaly Capital (NYSE: NLY  ) and Windstream (Nasdaq: WIN  ) , for example, have had payout ratios above 100% over the past two years. But before that, they routinely earned more than they paid out.

But to go five years straight without earning more than it pays in dividends, a stock has to come up with a better explanation. How can they do it?

Looking at the right ratio
In most cases, the answer lies in the difference between accounting-based earnings and actual cash flow. When you look at the companies above, REITs Realty Income and Simon Property, as well as telecom Frontier, have much higher free cash flow than their net income using GAAP accounting. Annaly and Windstream are in the same boat, justifying their high earnings-based payout ratios in recent years.

For Nordic American and Vector Group, the answer is more complicated. Nordic American pays dividends out of operating cash flow and issues new shares of stock to finance capital expenditures. Obviously, that works fine as long as investors are willing to buy those additional shares in secondary offerings. But if the capital markets ever dry up -- as they threatened to do during the financial crisis in 2008 -- then those dividends could go away as well.

Meanwhile, Vector Group can't cover its dividends from operating cash either. Instead, it simply issues more debt to cover its cash shortfall. Since 2006, Vector's debt level has quadrupled. Again, as long as Vector can borrow at reasonable terms, then this is arguably sustainable. But if bad times return, shareholders could find themselves without the income they've learned to expect.

Pay attention to payouts
Dividend stocks are a crucial part of your portfolio, but they aren't automatic moneymakers. If you keep an eye on your dividend stocks, you'll be better able to anticipate problems before they turn into the next dividend disaster.

Some dividends do make sense. Click here to get The Motley Fool's free report: 13 High-Yielding Stocks to Buy Today.

True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community.

Fool contributor Dan Caplinger thinks you'd be crazy not to have some dividend payers in your portfolio. He doesn't own the ones mentioned in this article, though. The Fool owns shares of Annaly Capital Management. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is crazy like a fox.


Read/Post Comments (8) | Recommend This Article (37)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2010, at 12:21 PM, gabbigirl wrote:

    I was researching REITs for my ROTH. NLY is one I especially liked. Any thoughts would be appreciated.

    Thanks for another great article.

  • Report this Comment On October 14, 2010, at 3:12 PM, mikecart1 wrote:

    I am also looking at NLY or CIM. It is like choosing between MO and PM. You can't go wrong!!!

  • Report this Comment On October 15, 2010, at 11:37 AM, offroadhero wrote:

    I got some NLY about a month ago. With this upcoming dividend I am looking at about 3.5% return in not quite 2 months. Its hard not to like them. Taxes are going to be a pain just like any REIT.

  • Report this Comment On October 22, 2010, at 1:42 PM, gimponthego wrote:

    I enjoyed the article as well! Not for lack of trying on my part, but does anyone know when NLY will be paying out their next dividend? Thanks! John

  • Report this Comment On October 23, 2010, at 1:00 AM, stockmover wrote:

    Hey John ...NLY will be making a .68 cents/share dividend payout on 10/28/10 . Their ex-dividend date was 9/30/10.

    Rich

  • Report this Comment On October 23, 2010, at 1:27 AM, goalie37 wrote:

    My problem with NLY is that they are in the mortgage and financing part of real estate. I prefer REITS that own land, have tenants, and charge rent.

  • Report this Comment On October 24, 2010, at 2:38 PM, MegaEurope wrote:

    Although FCF is higher than income for many REITs, it is still not enough to cover dividends at O, SPG and many others. After their huge runups 2009-2010 I think people should start taking profits.

  • Report this Comment On October 25, 2010, at 11:11 PM, King2fish wrote:

    NLY will probably look pretty until the interest rate spread reduces - I'd sell when Gov't starts causing interest rates to rise.

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