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 (NYSE:TGT), Wal-Mart (NYSE:WMT), and Kmart, to name just a few. By 1911, the company operated more than 500 stores, and in 1913, Woolworth's 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: Management wanted to appease longtime blue-chip investors. 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 Cintas (Nasdaq: CTAS) type, with a well-funded dividend that has been raised by 10% or more per year over the past five years, or of the unsustainable 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 that have no free cash flow and pay a dividend? Just as it's important to identify companies to invest in for the long term, we need to identify companies to avoid. Below are four companies that came up in a screen for companies paying dividends that have negative free cash flow or funds from operations (greater capital expenditures than operating cash flow).

Company

Free Cash Flow (TTM*)

Yield

Carmike Cinemas (NASDAQ:CKEC)

-$29.6

3.1%

Nautilus (NYSE:NLS)

-$13.0

2.6%

Hollinger International (NYSE:HLR)

-$259.9

2.2%

Glenborough Realty Trust (NYSE:GLB)

-$4.3**

7.2%

Numbers in millions. All data provided by Capital IQ.
*Trailing 12 months
**FFO used instead of free cash flow

Not only are all of the companies above free cash flow negative, but each also gives pause when looking at the level of debt each is carrying. 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. And while such strategies can work well for a few years, they are ultimately unsustainable. For now, it is safest to avoid these companies, though it is always possible that any of the four could become a future turnaround candidate.

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 real estate investment trusts (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 for 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 17.1% on the back of recommendations such as California Water Services, which has rewarded investors in the past two years with a total return of 69.2% and still offers a compelling 2.7% yield. To view Mathew's four dozen superior dividend payers, try a 30-day free trial to the newsletter. You'll enjoy access to all of the back issues and previous picks, the current risk-adjusted values, and 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 originally ran on July 15, 2005. It has been updated.

Nathan Parmelee does not own shares of any company mentioned in this article. The Fool has an ironclad disclosure policy .