Dividend investors love the Dow Jones Industrials (DJINDICES: ^DJI ) , because all 30 of its components pay dividends. But just because a company is a member of the Dow doesn't mean that it is immune from ever having to cut its dividends. By one popular measure of dividend sustainability, you could conclude that AT&T (NYSE: T ) , Verizon (NYSE: VZ ) , and Merck (NYSE: MRK ) might be paying out too much in dividends. But is that popular measure too simplistic? We'll look at that question later, but first, let's turn to the Dow's history of its component stocks paying dividends to their shareholders.
The Dow's dividend history
Dow stocks have suffered from dividend cuts in the past, even though they've often surprised investors in the process. During the financial crisis, for instance, many Dow investors got burned when General Electric (NYSE: GE ) and Pfizer reduced their dividends, slapping shareholders with the double-whammy of reduced income and a big decline in share price. In addition, several banks had to cut their payouts as a condition of receiving federal bailout money, creating further havoc among income investors.
Since then, GE and Pfizer have raised their subsequent dividends to restore much of the ground they lost. Many of the banks that reduced their dividends have gotten permission from the Federal Reserve to restore them to pre-crisis levels. Nevertheless, the episode served as a strong reminder to investors of what can happen under tough conditions.
Will the Dow's dividend stocks cut their payouts?
The reason AT&T, Verizon, and Merck come to dividend investors' attention is that they all have high payout ratios, in that their dividends are high in comparison to their earnings. In general, dividend investors prefer to see companies paying no more than they earn. Otherwise, part of the payouts they receive don't represent true net income of the company but rather simply reflect returns of capital from other parts of the business, or even reflect the need for the company to borrow from outside sources to make its quarterly payouts.
In the case of these three stocks, dividend payouts currently exceed earnings. For Verizon, S&P Capital IQ reports earnings of $0.77 per share over the past 12 months, compared to dividend payments of $2.08 per share. For AT&T, the corresponding figures are $1.37 per share in earnings and $1.80 per share in dividends, while Merck's numbers are $1.49 in earnings per share and $1.71 in dividends.
But the underlying assumption behind the earnings payout ratio is that earnings accurately reflect the cash that a company has on hand. With AT&T and Verizon, that assumption is patently false because of the huge capital infrastructure that the wireless-network giants have on their balance sheets. For instance, Verizon has claimed $16.6 billion in depreciation and amortization on its income statement over the past 12 months, pushing the company's free cash flow up to $18.4 billion. That's well over $6 per share in available cash for dividends, leaving Verizon with plenty of room to make its dividend payments. A similar situation faces AT&T, again because depreciating its wireless-network investments produces a wide disparity between available free cash flow and official earnings.
Merck, on the other hand, doesn't have that accounting excuse. Rather, the decline in Merck earnings has come as a result of the major patent cliff that the company has faced, especially as blockbuster Singulair came off-patent. Dividend investors have to hope that Merck's pipeline of drugs will produce replacements for the revenue that the company will lose to generic competition, but so far, that process has been arduous and has had only mixed success. Although few believe that Merck would cut its dividend, the company needs to demonstrate a solid turnaround before it will be out of dividend danger.
Checking in on your dividend stocks from time to time is a smart move. Even though some warning signs will turn out to be false, the exercise nevertheless keeps you alert to changing conditions that could threaten your dividend income in the long run.
Why dividends are so important
It's easy to discount the value of a payout of just a few percent every year. But the simple fact is that even with those puny payouts, dividend stocks can make you rich. Over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.