Can You Count on Your Dividends?

Got dividends?

Probably not as much as you previously thought.

The Associated Press recently reported that dividends "are being cut at the fastest pace in at least 50 years." What's more, the cutters aren't just dividend upstarts like Whole Foods, which only began paying a dividend in 2004. No, we're talking blue-chip dividend stalwarts -- like Bank of America (NYSE: BAC) and Citigroup (NYSE: C) -- both of which have reduced their quarterly dividend to $0.01 as part of their bailout terms. Others, like Pfizer (NYSE: PFE) and Dow Chemical (NYSE: DOW), have drastically cut their hefty yields to fund pricey acquisitions. Just yesterday, General Electric (NYSE: GE) announced a 68% dividend cut to help preserve its balance sheet and AAA credit rating.

It's not easy being a dividend
All told, as my Foolish colleague Ilan Moscovitz writes, a mind-boggling $22 billion in dividend payments were eliminated during this past quarter alone. This is especially distressing because it's estimated that more than half of America's retirees rely on dividend income to maintain their standard of living.

Was there any way investors could see this coming?

Perhaps.

Not every dividend cut mentioned above was expected, but many companies gave signs -- or are giving signs -- that a savvy investor could have noticed.

High expectations
It's important to remember that while the market is often irrational, it isn't always.

As such, a high yield is often indicative of underlying troubles because it indicates that shares have been beaten down to such an extent that investors have serious doubts about the firm's financial position. The company might go under, or, more likely, it could cut its dividend, thereby reducing the yield you thought you paid for. One could argue that this is the case at Allied Capital (NYSE: ALD), which currently yields a whopping 77.2%.

Bottom line: Investments in stocks with yields over 20% are better left to speculators.

High payouts
But even low-yielding companies can face a dividend cut. Perhaps the best way to assess both the near-term and long-term feasibility of a company's dividend is by determining the company's dividend payout to free cash flow ratio. This metric pits a company's annual dividend outflows against its annual free cash, i.e. the uncommitted cash a company is left with after maintaining its current business and investing in future business.

Companies have a very difficult time supporting free-cash-flow payout ratios above 100% because the only way to pay out more cash than they earn is to issue shares, issue debt, sell off assets, or deplete cash reserves -- none of which are sustainable over the long term.

By way of example, here are three such companies whose dividends might soon either go the way of the dodo or Grant Williams as evidenced by this ratio:

Data from Capital IQ, a division of Standard & Poor's.

China Mobile has done an excellent job growing its business, but all that growth costs money, and last year's whopping $24 billion capital expenditure budget will make it very difficult for the company to continue to afford paying out $5 billion a year in dividends. Luxottica's dividend is paid out as a percentage of earnings, but the company has upcoming debt obligations, so it may make the choice to pay out a smaller amount in the future. Boston Properties, like many other heavily indebted REITs, faces a double-whammy in the form of tight credit and a brutal commercial real estate market; the architecture billing index, a leading indicator of commercial construction spending, sits at an all-time low.

Dividend defense
Though I in no way mean to argue a forsaking of dividends altogether (in fact, I think now is an opportune time to pick up solid dividend-paying companies), it is extremely important to be on the defensive against companies that are spending more dividends than is feasible given our economy's current environment. The stakes have changed.

This is exactly the tactic the team at Motley Fool Income Investor, led by former hedge fund analyst James Early, is employing in the current environment so hostile to dividends. They are assessing the strength and sustainability of the market's top dividend-paying companies. You can see their top recommendations completely free for the next 30 days. Click here for more information.

Fool analyst Adam J. Wiederman owns shares of General Electric, but of no other company mentioned above. Pfizer is a former Income Investor recommendation and Fool holding, as well as a current Inside Value selection. Luxottica is a Global Gains pick. The Motley Fool has a disclosure policy.