5 Signs of a Questionable Dividend

The dividend carnage of the financial crisis remains fresh in the minds of many dividend investors. All told, there were a record 804 dividend cuts in 2009 that cost investors some $58 billion in income, according to Standard and Poor's.

Gone are the days when you could buy a dividend-paying stock simply because it's a blue chip and then forget about it until retirement.

Though the dividend landscape has improved dramatically since the financial crisis, in recent months we got a reminder of the sting of dividend cuts when Hudson City Bancorp cut its payout.

With that in mind, it seems a good time to review the basics of identifying questionable dividends.

Red flags
When researching strong and sustainable dividend-paying shares for your portfolio, you'll want to seriously question those that meet any of these five criteria.

1. An abnormally high yield
Companies whose dividend yield is well above the market or industry average are more likely to reduce their payout in difficult environments.

When Pfizer (NYSE: PFE) acquired Wyeth in January 2009 and announced its dividend cut, it was yielding more than 8% while the S&P 500 yield was around 3%. In the press release that announced the acquisition and dividend cut, Pfizer argued that despite halving its payout, the new yield (around 4%) "continues to be competitive with other industry participants."

What did they mean by that? At the time, Merck and Bristol-Myers were yielding between 5% and 6%, so Pfizer may have thought the 8%-plus yield that it was paying was too high relative to its peers. The combination of the Wyeth acquisition and the financial crisis seems to have provided the board with an opportunity to reduce its quarterly cash payout to shareholders.

As you evaluate high-yield dividend opportunities, be sure to compare a stock's yield to not only the market average, but to its peer group, as well.

2. Declining sales
Sales are the life blood of a company, so if sales are declining, that can put pressure on margins, profits, cash flows, and eventually the dividend.

Companies tend to react to negative sales growth by cutting costs to maintain profit levels, repurchasing stock to boost EPS growth, or making sometimes costly acquisitions to boost group sales. All of these things can have negative effects on the dividend policy.

Eastman Kodak is a classic example of declining sales leading to dividend cuts. Kodak suspended its quarterly dividend in early 2009 following sales declines in each of the previous four years.

3. A weak balance sheet
Creditors have a greater claim to a company's earnings and assets than common shareholders do. If a company can't repay its creditors, it won't be able to pay you dividends. It's really that simple.

A company with an interest coverage ratio (EBIT/interest expenses) below three may be in danger of being unable to repay its creditors. In 2008, International Paper (NYSE: IP) had an interest coverage ratio of 2.5 times, and just a few months later it cut its dividend by 90% in an effort to conserve cash and repay debt.

4. Stalled dividend growth
A company whose dividend growth has slowed or stalled could be in the process of rethinking its dividend policy or may not be confident about its future.

To illustrate, before Newell Rubbermaid cut its dividend in early 2009, it had maintained a $0.21 per share quarterly dividend for eight years with no increases. Over this period, profits were quite volatile, and the payout often exceeded earnings for a given year. Frankly, it's incredible that Newell Rubbermaid was able to maintain that payout as long as it did.  

5. Lack of dividend cover
Companies that aren't generating enough profit and free cash to cover their dividend payouts are at a greater risk for dividend cuts. This isn't exactly a groundbreaking revelation, but it's certainly worth repeating.

In 2008, for example, Dow Chemical earned just $0.37 in profit for each $1 it was paying out in dividends, and Fortune Brands generated $0.63 in free cash for each $1 it paid in dividends. It's unsurprising, then, that both companies cut their dividends in early 2009.

Getting better all the time
If you're looking for stocks that can provide a steady stream of dividend income, there's little reason to take undue risk when there are plenty of good options to consider. Even during 2009, the worst year for dividends in more than 50 years, more companies increased their payouts than cut or suspended their dividends.

Dividend-minded investors should look for stocks with reasonable yields, a good track record of dividend growth, plenty of profit and free cash flow cover, and that are supported by a solid balance sheet.

Here are five companies that fit these criteria:

Source: Capital IQ, a division of Standard & Poor's, as of July 26.

As always, these stocks aren't presented as official recommendations, but as ideas for further research. If you'd like to read about some more of The Fool's dividend ideas, please click here to receive our free special report: "13 High-Yielding Stocks to Buy Today."