These Dividends Are Done

It's been a scary crisis for dividend investors.

Even with the recent rally, a lot of dividend yields are sky-high. According to Capital IQ, there are 827 stocks on our major exchanges with yields of 5% or more. But many of these are dividend traps, enticing us with the promise of fat quarterly payouts, only to cut them down the road.

As a stark reminder, we can look to General Electric. Once hailed as the safest of the safe, we watched as GE received government help, cut its dividend to save cash and (hopefully) retain its AAA debt rating, and then lost that AAA status anyway.

More examples abound. Harley-Davidson (NYSE: HOG) dropped its dividends by 70% and required an expensive loan from Warren Buffett. Nokia (NYSE: NOK) pays its dividend annually and not in a regular amount, but it's still notable that its dividend dipped by a third from 2008 to 2009. PNC's (NYSE: PNC) dividend dropped to a nominal level, but that was par for the course among the big banks.

Going forward, Harley-Davidson's dividend is currently easily covered by cash flows, but at 1.3%, it's almost immaterial to investors who crave regular payouts. Nokia still sports a 5.2% yield, but its sustainability is seriously threatened by stiff and strengthening competition in the mobile handset space. Like Harley-Davidson, PNC's 0.6% dividend yield is almost immaterial, and like Nokia, it faces serious threats, this time from government regulation.

The "5% of nothing" club
As these cautionary tales show, dividends can be dangerous -- especially if the great double-whammy curse of high-yielding stocks kicks in.

We buy dividend stocks because they provide a large, steady stream of income and have the promise of stock price appreciation. But then:

• In a turbulent environment, a susceptible high-yielding company's share price takes a beating. (Whammy!)
• To preserve precious capital, said company cuts or altogether eliminates its dividend, destroying dreams in the process. (Double whammy!)

As a result, I view any dividend yield as a "too good to be true" situation until I've fully vetted the company. It's a good default stance on any stock you're considering buying. Let's take a quick look at some companies with 5%-plus dividends:

Source: Yahoo! Finance.

The story behind the numbers
The first thing I do when I see a tasty dividend is look for obvious problem areas. If I can spot a major problem quickly, it saves me further research.

Notice the payout ratios (the percentage of earnings a company pays out in dividends) in the table above. If I see a payout ratio greater than 50% (as is the case with all five companies listed above), I get suspicious. When the payout ratio goes above 100%, a company's earnings aren't enough to cover its dividends (Deutsche Telekom).

Worse than a payout ratio greater than 100% is a negative ratio -- it means the company is paying out dividends despite reporting a loss.

While I would certainly take a good hard look at the earnings quality of the five companies above with payout ratios greater than 50% (or any company, for that matter), I'd be especially skeptical of the dividend sustainability of Deutsche Telekom -- given its sky-high payout ratio.

Now, keep in mind that the payout ratio is just one metric. It's certainly useful for screening purposes, but further research fills in the picture. For instance, those making the bull case for Deutsche Telekom would point to the company's hefty free cash flow as evidence of dividend sustainability.

Which dividends will survive?
It's darn hard to determine the sustainability of dividends in this environment. Due diligence is important in any environment, but it's especially important now, when we have to differentiate between high-dividend plays that could form the core of our portfolios for decades to come and future cautionary tales of dividend despair.

The folks at our Motley Fool Income Investor newsletter do their homework. They look for the most stable companies that pay the highest, most sustainable dividend yields. Of the companies in the table above, they have recommended Philippine Long Distance Telephone to their members.

However, for new money, they've identified five sustainable dividend-paying stocks as "buy first" candidates. Philippine Long Distance Telephone doesn't currently make the cut. You can see all five that do, and try out the entire service for free, with a 30-day trial. Click here to learn more -- there's no obligation to subscribe.

This article was originally published May 7, 2009. It has been updated.

Anand Chokkavelu owns shares of Altria. In his spare time, he hosts a snack-food program called These Doritos Are Done. Nokia is a Motley Fool Inside Value recommendation. Philippine Long Distance Telephone is an Income Investor pick. The Fool has a disclosure policy.