We talk a lot about the market being inefficient and not always a good measure of a company's performance. That statement should always be qualified with "for short periods of time." Generally that means weeks or months, but in the long run, the market always gets it right.

The most recent example that springs to mind is yesterday's announcement by Pier 1 Imports (NYSE:PIR) of its intention to cut its dividend. The stock fell nearly 10% briefly yesterday but ended up closing only about a dime (1.9%) below where it had closed the day before. Considering the company's 5.2% dividend was cut entirely, that's not a large fall.

I believe the reason Pier 1's shares were so strong is that most people, including me, considered a dividend cut inevitable. To anyone following the company's sales and cash flow woes, the writing had been on the wall for some time. The real surprise was that the dividend cut took this long to be decided upon.

The reason a dividend cut was so likely for Pier 1 was its consistent decline in free cash flow. From 1997 to 2003, Pier 1 easily earned more than enough free cash flow to cover its dividend many times over. However, starting in 2004, the story changed. At first, in 2004 and 2005, the company was still earning operating cash flows, but capital expenditures to fund its expansion were more than consuming the operating cash flows generated. To fund its remaining capital expenditures and its dividend, Pier 1 started eating into its cash balances. If the company believed its slowdown in cash flow growth was temporary -- and almost all companies think this at first -- eating into the cash cushion on the balance sheet was a reasonable action.

However, the company's fiscal 2006 showed negative operating cash flow, meaning the company was already eating cash before funding any of its expansion or maintenance capital expenditures. Pier 1 earns most of its cash flow during its fourth quarter, and when last year's fourth-quarter results were weak, it was clear to me that the company's dividend-paying days were likely numbered. But the company kept the payouts going and continued eating into its balance sheet until yesterday.

This is not a huge surprise. Most companies are reluctant to cut their dividend once it is in place, because of the message it sends to investors and the likelihood of driving off investors who are primarily invested for the dividend. But since free cash flow is the lifeblood of a business, cutting a dividend can be the best thing for a company to do, because it allows it to retain cash to make investments and fix what ails it without taking on debt at a time of weakness.

Income Investor selection Heinz (NYSE:HNZ) went this route and ratcheted back its dividend in 2003 and 2004, but with its cash flow once again stable and growing, its dividend is now growing again as well. In the last year, dividend reductions have also been made at ConAgra (NYSE:CAG) and Ford (NYSE:F), because dividend payments were exceeding the free cash flow available for dividends. With any luck, Pier 1, ConAgra, and maybe even Ford will be able to right themselves as Heinz did. Considering retailers tend to have nine lives, I'd certainly keep an eye on such a scenario playing out for Pier 1.

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At the time of publication, Nathan Parmelee had no positions in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy.