Don't Trust This Yield

A few months ago, I went looking for the highest dividend payer in America. The winner? GateHouse Media, which boasted a whopping 150% dividend yield.

With a dividend like that, even if the stock price did nothing over the next year, you'd still more than double your money. But you knew there was a catch, right?

Here it is: The company hasn't been profitable since 1997. Its grand business plan is newspapers and Yellow Pages.

It's not hard to see how a situation like that -- absurdly high dividend, out-of-step business plan -- turns into a shattered dream. In fact, on Aug. 8, GateHouse suspended its dividend altogether.

But what about situations that aren't so clear-cut?

Are these yields believable?
Not all companies are as easy to dismiss as GateHouse -- nor are their dividend cuts so easy to predict. Check out these big-name dividend-paying companies that substantially beat the 3.3% yield you can currently get on a 30-year Treasury bond:

With dividends like that, an increase in the stock price is just a bonus. That's why dividend payers are popular core holdings in many people's portfolios.

But if the stock price falls -- and the company cuts its dividend, too -- that solid core can start to look like Swiss cheese.

How can you tell?
Want to know whether a company is likely to slash its dividend? All you have to do is answer one question: Will a company's future earnings support its future dividend payments?

But as investors can tell you -- especially the ones who have been burned by the recent dividend-slashing at seemingly rock-solid companies -- figuring that out is much harder than it sounds.

A year and a half ago, for example, few people would have predicted the devastation the financial sector has experienced. We've seen dividend cuts precede the downfalls of Wachovia and Washington Mutual, leaving us to wonder about the viability of dividend-slashers like Bank of America and KeyCorp (NYSE:KEY) and dividend-warners like Blackstone (NYSE:BX). Even seemingly secure dividends such as Wells Fargo's 4.7% yield and Goldman Sachs' paltry 1.8% yield are called into question in this atmosphere.

How can we separate the dividend dynasties from the dividend destroyers?

To get some pointers, I turned to experts James Early and Andy Cross, co-advisors at our Motley Fool Income Investor investing service. They point to four factors:

• Strength of management: Is management composed of competent leaders with a proven track record and years of relevant company and industry experience? Have they been able to raise dividends in good times and bad?
• Size: Does the company have a substantial market cap? Although it's possible to find solid small-cap dividend payers, James and Andy generally look for companies capitalized above $1 billion, to cut down on volatility.
• Financial fortitude: Does the company have a solid balance sheet and strong cash flows? Substantial debt combined with weak performance leads to dividend cuts.
• Competitive advantage: Is the company better positioned strategically than its competitors are?

Positive answers to all of these questions won't necessarily prevent a dividend from being slashed -- unexpected events will always arise -- but it's a good place to start.

The lesson?
As we saw in the GateHouse example, the future success of a company can't be distilled into one metric, like dividend yield. To make an informed investing decision, you really do have to do your homework -- read financial statements, check up on management, analyze competitors, listen to quarterly conference calls, and crunch the numbers.

Those four bullet points above are a good place to start. If you need additional help or specific stock ideas, check out Income Investor. The team recently reviewed every dividend stock they've ever recommended; you can see what they're bullish on now by clicking here for a free 30-day trial. There's no obligation to subscribe.

This article was originally published Aug. 22, 2008. It has been updated.

Anand Chokkavelu doesn't own shares in any company mentioned. Bank of America is a Motley Fool Income Investor recommendation. Nissan Motor is a Global Gains pick. The Fool has a disclosure policy.