Stocks with high dividend yields can do wonders for a portfolio. If you buy shares of a company that pays 6%, 8%, or even 10% annually and get a capital gain, you're pretty much assured of beating the market.

The problem is that high yields also tend to be unreliable.

High-yield headaches
High-yield stocks are only worthwhile when investors receive the advertised return. As valuation luminary Aswath Damodaran told Fool co-founder Tom Gardner in a recent interview, "High dividend-yield stocks are [only] attractive if you can expect the company to keep paying those dividends."

How do Fools separate jackpots from time bombs? Cash. Is the company generating enough free cash flow (FCF) from operations to cover its dividend, or is it borrowing money or using one-time gains (such as selling assets) to meet obligations? If it's the latter, a cut could be in the making. Here are three companies I profiled back in January that were paying out more than they were earning:

Company

January 2006 Yield

January 2006 Payout Ratio*

General Motors (NYSE:GM)

10.6%

N/A (negative net income)

Reddy Ice (NYSE:FRZ)

6.9%

N/A (negative net income)

American Financial Realty (NYSE:AFR)

8.9%

N/A (negative net income)

*Trailing 12 months.

GM was a disaster waiting to happen, and the company cut its dividend in half in February. The stock now yields just 3.8%, and while its cash hoard can support it for a bit, even today's reduced dividend is not sustainable if the automaker doesn't start making money.

Reddy Ice, on the other hand, actually increased its dividend from $1.53 to $1.60 annually (now yielding 7.5%) despite the company's continued losses. CEO William Brick said in the company's recent release, "Based on the performance of our operations over the last nine months, our recent acquisitions and the outlook for the remainder of 2006 and the foreseeable future, we are pleased to be able to increase the dividend to our shareholders." Management's outlook aside, this is still one I'd be wary of.

High-yield opportunity
American Financial Realty, a Motley Fool Income Investor recommendation, is a more interesting story. Its dividend has stayed the same since January, but the yield is now 10.3% because the stock price has kept dropping. Because the company operates as a real estate investment trust (REIT), its payout is necessarily high. But when analyzing REITs, the key statistic is funds from operations (FFO), not FCF or net income. To calculate FFO, add back depreciation and amortization to net income -- a number that is often high, since REITs deal in real estate.

American Financial has trailing-12-month FFO of approximately $90 million -- far less than it needs to cover the dividend payments it's on the hook for in the coming year. But get this: American Financial also defines FFO differently from the accepted definition, because of its practice of selling non-core properties, and the company believes it will be able to fund the dividend. This changing definition has spooked analysts and investors and kept the stock price down.

Can the company do it? Management seems to think so, and CEO Louis Ranieri was adamant recently that the stock is undervalued. Many analysts, however, disagree. They're skeptical of the company and its ability to fund the dividend. But that's why we have the outsized yield today.

Foolish bottom line
American Financial is not a clear-cut play. But if it were, the big yield wouldn't be there. See, yields decline as prices rise. A reliable 10% yield in an efficient market is like a wounded tuna to a shark -- it's not going to last very long.

You can always stick with the conservative and covered yields like the 1.6% yield and 29% payout offered by Microsoft (NASDAQ:MSFT), the 1.4% yield and 25% payout from Wal-Mart (NYSE:WMT), or even the 2.9% yield and 63% payout of General Electric (NYSE:GE), but the potential reward isn't as great as doing the due diligence on a company like American Financial. A 30-day free pass to Income Investor, on the other hand, will give you the inside track on the best and biggest yields the market has to offer, including two of the market's most overlooked REITs. The secret is cash and the cash can be yours. Click here to learn more.

This article was originally published on Jan. 6, 2006. It has been updated.

Tim Hanson does not own shares of any company mentioned. Microsoft and Wal-Mart are Motley Fool Inside Value recommendations. No Fool is too cool for disclosure.