With the S&P 500 still down more than 30% since the start of 2008, many wary investors have been turning to the safety of dividend-paying stocks. In just the last three months of '08, for example, domestic dividend-focused ETFs that invest in high-yielders experienced net inflows of $1 billion.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the present one are leaving many companies with little choice but to reduce or omit payments. According to data from Capital IQ, some 370 companies cut their dividends last year, and their stock prices had an average return of negative 56% for the year. While in 2009, companies such as IBM (NYSE:IBM) and Northrop Grumman (NYSE:NOC) still continue raising their payouts, declines are outnumbering raises among members of the S&P 500. BB&T (NYSE:BBT), SunTrust (NYSE:STI), and Simon Property Group (NYSE:SPG) are just some of the latest victims.

So how can you tell whether your company is about to make a cut? Last December, I argued that Frontline and Host Hotels were risking dividend cuts. (Both have since done so.) Among the warning signs these companies exhibited:

  • High yields
  • High payout ratios
  • Industry headwinds

Extremely high yields signal investors' skepticism that the company will be able to maintain its dividend. When National City announced its first dividend cut last year, for example, the stock was "yielding"10%. Since then, the stock plunged, and the company was acquired by PNC (NYSE: PNC). A high payout ratio -- particularly when combined with a difficult operating environment -- suggests that the company doesn't have enough free cash flow to support its payouts.

But these factors don't necessarily imply that a cut is imminent. Many other companies have continued to pay dividends they cannot afford for years, damaging their own firms -- and the value of your shares -- in the process.

I'll spare you all the details
A fascinating 2004 survey explains how and why. A team of four professors from Duke and Cornell surveyed more than 400 financial executives, discovering that 94% of executives "strongly ... or very strongly ... agree that they try to avoid reducing dividends." Many admitted to selling assets, laying off employees, borrowing heavily, or omitting important projects before cutting dividends.

See, these managers know that the market reacts negatively to dividend cuts. Several executives noted that Wall Street's response is an especially important consideration during liquidity crises -- such as the present one -- because they wouldn't want lenders to think their company is struggling.

But let's get back to payout ratios. Unfortunately, if a company isn't generating enough free cash flow to support its payout, the extra cash has to come from someplace else. Aside from raising revenue or cutting expenditures, there are four basic ways a company can collect the cash it needs to make such payouts:

  • Burn existing cash reserves
  • Borrow money
  • Issue shares
  • Sell assets

And while some of these practices may be acceptable Band-Aids for a difficult year, none is sustainable over the long term. A company that pursues these strategies for too long will eventually burn itself out, damaging its shareholders in the process. Even worse, it's likely that it will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Three companies risking a burnout
These three companies have paid out more in dividends than they took in as free cash flow (or were free cash flow-negative) over the past three years:


Net Income Payout Ratio, 2008

Free Cash Flow Payout Ratio, 2008

Total 3-Year Shortfall*

Primary Funding Method

American Capital (NASDAQ:ACAS)



$637 million

Issue shares and debt, sell assets

Dominion Resources



$8.0 billion

Sell assets

Nordic American Tanker



$432 million

Issue shares

Data from Capital IQ, a division of Standard & Poor's.
*Calculated as total dividends paid minus free cash flow.

As a Regulated Investment Company, American Capital is required to pay out 90% of its taxable income in the form of dividends. For the past few years, the company could afford to do so by diluting shareholders and issuing debt (and, last year, selling investments). Annualizing the upcoming distribution shows the stock yielding more than 130%. But investors should be aware that it could become more difficult to support that dividend in the future. That’s because the private equity firm's cost of capital is rising, thanks to a recent credit downgrade and $2.3 billion of unsecured debt currently in default.

While Dominion may appear to have adequate net income to cover its dividends, it's important to remember that net income is an accounting construction. It doesn't always reflect how much cash a company actually has left over to cut your check. Free cash flow payout ratios often provide a more accurate picture. Dominion has recently sold off billions in assets; it's been largely free cash flow-negative, yet it has continued to pay its large dividend.

Nordic American doesn't pay a set dividend -- it distributes cash to shareholders based on its net operating cash flow -- but over the past five years, the company hasn't had a single year in which free cash flow outstripped the amount of cash paid to shareholders.

To his credit, Nordic American's CEO is honest about his company's strategy of supporting large dividend payouts with massive share issuances. As he recently told my colleague Mike Pienciak, "Given that Nordic American pays out all earnings as dividends, a growth model that relies on retained earnings is not right. Rather, Nordic American will continue to go to the capital markets." But that seems a little like the company is paying the left hand with the right hand, and the right hand with its foot.

The silver lining ...
Dividend stocks have a history of putting money in investors' pockets, but choosing the right dividend stocks for a down market is critical to protecting your portfolio. Paying close attention to how your company funds its dividend will help you achieve the golden returns dividends offer.

If you'd like to see the stocks our team at Motley Fool Income Investor likes, including their six "Buy First" dividend payers, you can try the service free for 30 days. Click here for all the details -- there's no obligation to subscribe.

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Ilan Moscovitz is neither long nor short any companies mentioned in this article. The Motley Fool has a disclosure policy.