Could These Dividend Stocks Wreak Havoc on Your Portfolio?

Usually, dividend stocks are a safe-haven for investors going into recessions, and a number of commentators thank recession is exactly where we're going.

And even when it's not a recession, as Jeremy Siegel said in his The Future for Investors, "Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run."

Today, I'm taking that popular sentiment, and showing you where the appeal of fat dividend yields could lead you to add some truly toxic stocks to your portfolio.

By the time I'm done, you'll have a better understanding between dividend contenders and pretenders. And at the end, I'll offer you access to a report with 11 big-time contenders for the dividend-investor's portfolio.

Fat yields
Of course, you'd never be tempted to add these stocks if there wasn't something appealing about them. One look at the current yields of the following seven stocks makes it crystal clear why many a dividend investor is excited to buy them.

Source: Yahoo! Finance.

Dividends like these would make any investor salivate. But a deeper dive will reveal that while some stocks may be shiny and appealing on the outside, they may be rotting on the inside.

Where'd my money go?
While dividends may be nice, they'll mean very little if the actual price of the underlying stock they come from depreciates markedly in value. To figure out if these companies are overpriced, I took a look at their PEG ratios.

In the most basic sense, a PEG ratio of 1 represents a stock that is fairly priced relative to its expected growth. The higher the PEG ratio (especially above 1.5), the more overpriced the stock may be.

Source: Yahoo! Finance

Of course, analysts are notoriously wrong when it comes to precisely nailing down how much growth the future holds for a particular company. But with these seven, the consensus seems to be unanimous; these stocks are priced for heavy future growth. If they fail to deliver on this promise, share prices could plummet.

Will this dividend even be around for long?
Let's say that the actual price of the stock stays stable. Even that won't be enough if the company isn't able to keep paying out its dividend in a sustainable manner.

One of the most popular metrics for checking on a dividend payer's sustainability is the earnings payout ratio, which essentially measures the amount of earnings a company dedicates to paying out dividends. As the theory goes, the higher the payout ratio is, the less sustainable the dividend is. If the ratio is above 100%, that means the company is using more than it takes in from earnings to pay off the dividends.

Source: Yahoo! Finance.

If a company is already paying out more than it takes in, a dividend cut or suspension could easily be on the horizon.

But wait, there's a catch
This is where things get tricky. Because earnings are reported using the accrual method, companies may not yet have collected all of the money that they say they've earned. Things like accounts receivable and payable, depreciation, and goodwill are included in earnings -- but they don't immediately affect the amount of money a company has in the bank.

The good news is that there is a way to see how much money a company has put in the bank: free cash flow. This number is very important -- some Fools would say more important -- in evaluating a company's dividend sustainability. Ultimately, dividends are paid from free cash flow, not from earnings.

Check out the free cash flow payout ratio for these companies over the past 12 months, and the story changes considerably.

Source: S&P Capital IQ.

All of a sudden, the picture becomes much clearer. Though they still have high PEG ratios, Nokia and Frontier are clearly dividend contenders. WWE and Otter Tail, on the other hand, look more like pretenders than anything else given their high FCF payout ratios. And Altria (which had an enormous change in settlement-related liabilities during the second quarter), as well as New Zealand Telecom and Teekay Tankers, exist somewhere in between the two groups for now.

11 more dividend contenders
If you'd like access to 11 companies that the Motley Fool's senior analysts have hand-picked as excellent dividend stocks, I encourage you to check out "Secure Your Future With 11 Rock-Solid Dividends." The report, our newest one available, will tell you all about why these 11 companies deserve your attention. The report is yours today, absolutely free!