Avoid a Dividend Disaster

Woolworth's was a company with a rich history. Founded in 1879 by entrepreneur Frank Woolworth, the five-and-dime store was a precursor to the retail behemoths that dominate the commercial landscape today: Target, Wal-Mart, and Costco (NASDAQ:COST), to name just a few. By 1911, the firm operated more than 500 stores and in 1913, Woolworth constructed the Woolworth Building in New York City. At the time, it was the tallest building in the world. The company had the makings of an empire.

Fast-forward to 1997. Woolworth's was out of business -- though a portion of it survives as Foot Locker -- and Wal-Mart had booted it from the Dow. For investors on autopilot, it was a very rude awakening.

What happened
The main culprit behind Woolworth's demise was competition. But suffice it to say, management sat on its hands as the business deteriorated beyond repair. One of the reasons for the destruction? Dividends.

"Dividends?" you're shouting in disbelief. "It can't be! Dividends are our friends."

But in Woolworth's case, they were crucial to the company's undoing. With the company struggling, management insisted on continuing to pay its dividend even though earnings did not support the practice. The reason: They wanted to appease longtime blue-chip investors. In order to find the cash to pay the dividends, Woolworth's assumed debt ... then more debt ... and then even more debt. Finally, it was just too much. The company was forced to slash its dividend, but by then, the end was near. A company that had been part of America's consciousness and the site of the famous Greensboro, N.C., civil rights sit-in was finished -- leaving empty stores, broken investors, and out-of-work Americans in its wake.

So how can investors tell whether their dividend payer is the Procter & Gamble (NYSE:PG) type, with a well-funded dividend that has been raised for 49 consecutive years, or of the unsustainably Woolworthian sort?

Four companies that can't fund their dividends
One of the traditional rules of dividend investing is to avoid companies that pay out too much of their free cash flow (FCF) as dividends. But what about those who have no free cash flow and pay a dividend? Just as it's important to identify the companies to invest in for the long term, we need to identify the companies to avoid. Below are four companies that came up in a screen for non-financial companies paying dividends that have negative free cash flow (greater capital expenditures than operating cash flow).

Like Woolworth's, General Motors and Dana have long, proud histories, but are feeling the pains of competition and a tough business environment. Neither has funded its dividend payments with free cash flow in at least two years. To get around the cash flow problem companies will often take on debt, sell assets, or begin to burn through the cash in the bank from previous years when business was strong. General Motors and Dana both show signs of this on their balance sheet. And while such strategies can work well for a few years, they are ultimately unsustainable.

Go with the cash flow
One key to finding dividend performers -- and dividend payers are performers, having outrun their non-dividend-paying counterparts in the S&P by a compounded rate of more than 3% in each of the past 25 years -- is to look for companies that pay out less than 60% of FCF, utilities that pay out less than 75% of FCF, or REITs that pay out less than 85% of funds from operations (FFO). These are sustainable dividends that will be rising long enough to enhance the returns of you, your children, your grandchildren, your great-grandchildren ... you get the point.

Find superior dividends
Master dividend investor John Neff guided his Windsor Fund to market-beating returns by finding superior dividends that rose year after year. After all, he learned from Graham and Dodd that yield is the most assured part of growth.

At Motley Fool Income Investor, lead analyst Mathew Emmert scours the market to find today's superior dividends. Conservative payout ratios are one criterion he uses to identify these opportunities, and to date, he's scored an average total return of 15.4% on the back of recommendations such as AGL Resources (NYSE:ATG), which has rewarded investors in little more than a year with 35.6% returns and still offers a compelling 3.4% yield. To view Mathew's four dozen more superior dividend payers, try a 30-day free trial to the newsletter. You'll enjoy access to all the back issues and previous picks, the current risk-adjusted values, and to the Income Investor discussion boards, where Mathew and team post regularly, and where like-minded investors share their ideas and analyses.

Foolish final words
Surprisingly, it's often not the size of the dividend that matters, but the quality. Staying on top of how your company funds its dividend and its underlying business prospects isn't simple, but that's the way to keep your dividends and portfolio rising for generations.

This article was originally published as "Dividend Disasters" on July 15, 2005. It has been updated.

Nathan Parmelee owns shares of Costco but no other company mentioned in this article. Costco is a Motley Fool Stock Advisor recommendation. The Fool has an ironcladdisclosure policy .