These Dividends Are Crazy!

Great dividend stocks are an investor's best friend. But if a company's just fudging the numbers to make a juicy payout, should you really bet your life savings on it?

Why dividend stocks rule
It's easy to understand why smart investors look closely at stocks that have a long history of paying stable, growing dividends. The best dividend stocks have all the hallmarks that investors look for in an investment:

• Profits. Companies that don't earn money can't afford to pay dividends. Most companies won't pay a dividend until they reach profitability and gain confidence that they'll stay profitable for the long haul.
• Growth. Similarly, companies that are able to raise their dividend payouts consistently over time have to find ways to grow their core business to generate ever-increasing profits.
• Commitment to shareholders. Other methods of using excess capital, such as stock buybacks, can often benefit option-holding executives as much as, or more than, ordinary shareholders. Dividends, on the other hand, go straight to shareholders, raising no worries about whether company insiders get unfair advantages.

These days, some yields are so high that they look too good to be true. One way to get a sense of whether a company's dividend payments are sustainable is to look at its payout ratio -- how big the dividends are compared to the company's earnings.

I expected that the most popular dividend stocks would have favorable payout ratios to support their current dividends and future payout growth. Yet when I looked more closely, I found a surprising number of dividend stocks that consistently pay more in dividends than they earn. Here are some of the biggest stocks that had payout ratios above 100% in each of the past five years:

Source: Capital IQ, a division of Standard & Poor's.

Some of those figures look positively astounding. It's easy to understand how a company can survive a year or two of oversized dividend payouts. Both Annaly Capital (NYSE: NLY) and Windstream (Nasdaq: WIN), for example, have had payout ratios above 100% over the past two years. But before that, they routinely earned more than they paid out.

But to go five years straight without earning more than it pays in dividends, a stock has to come up with a better explanation. How can they do it?

Looking at the right ratio
In most cases, the answer lies in the difference between accounting-based earnings and actual cash flow. When you look at the companies above, REITs Realty Income and Simon Property, as well as telecom Frontier, have much higher free cash flow than their net income using GAAP accounting. Annaly and Windstream are in the same boat, justifying their high earnings-based payout ratios in recent years.

For Nordic American and Vector Group, the answer is more complicated. Nordic American pays dividends out of operating cash flow and issues new shares of stock to finance capital expenditures. Obviously, that works fine as long as investors are willing to buy those additional shares in secondary offerings. But if the capital markets ever dry up -- as they threatened to do during the financial crisis in 2008 -- then those dividends could go away as well.

Meanwhile, Vector Group can't cover its dividends from operating cash either. Instead, it simply issues more debt to cover its cash shortfall. Since 2006, Vector's debt level has quadrupled. Again, as long as Vector can borrow at reasonable terms, then this is arguably sustainable. But if bad times return, shareholders could find themselves without the income they've learned to expect.

Pay attention to payouts
Dividend stocks are a crucial part of your portfolio, but they aren't automatic moneymakers. If you keep an eye on your dividend stocks, you'll be better able to anticipate problems before they turn into the next dividend disaster.

Some dividends do make sense. Click here to get The Motley Fool's free report: 13 High-Yielding Stocks to Buy Today.