As a beginning investor, I was fascinated with the concept of dividends.
"Own a piece of the company, and get paid for it? Don't mind if I do!"
I searched the Internet up and down looking for companies that were paying huge dividends.
Things have changed for me since then, as I've refined my own personal investment strategy. I wouldn't be surprised, though, if several other beginning investors do the same thing -- endlessly search for big payouts.
If you happen to be one of those beginning investors looking for a big dividend, I'm highlighting three companies below that will definitely look tempting, but that you should stay away from unless you understand the risks. Read all the way to the bottom and I'll offer access to a special free report from our top analysts highlighting nine rock-solid dividend payers.
Windstream is a domestic telecom company headquartered in Little Rock, Ark. If you run a quick screen for big dividends, you'd see that it currently offers up a 10% yield. But don't let that enormous payout fool you: The company is struggling to keep paying its dividend.
One of the best ways to measure if a company's dividend is healthy is to check its payout ratio from free cash flow. In plain English, this metric takes the amount of cash a company takes in during a year and tells you how much of that cash is being used to pay the dividend.
If the payout ratio is 20%, then a company's dividend is pretty safe -- as it has a nice cushion. If it is approaching -- or goes over -- 100%, then it's clear that the company is straining to keep making its dividend payment.
Over the past 12 months, Windstream has brought in $604 million in free cash flow. Over the same time period, however, it has paid out $550 million in dividends. That means that 91% of the company's cash is being used to pay the dividend.
If business declines in any way, then it will be extremely difficult to keep paying out this dividend. Between 2009 and 2011, the company's free cash flow shrunk 36% -- which is not a good sign. That said, the past six months have seen a 30% uptick in free cash flow.
Fellow Fool Eric Bleeker believes the company's future focus on commercial businesses could be a saving grace, but it's important to understand all of the variables before diving in headfirst for this 10% yield.
Roundy's is a company that I'm very familiar with, as its line of Pick 'n Save and Copps supermarkets are mainstays in my native Wisconsin. A quick Internet search will show you that the company is currently yielding a whopping 14.4% dividend.
And if we were to run the numbers very quickly, we'd see that the company has a payout ratio from free cash flow of 63%. That's not super-low, but it's also not alarmingly high.
But there's a catch here. The company just went public this year -- mainly because the owners couldn't find anyone to take the business off their hands. While the company's free cash flow represents two quarters of business, there's only one quarter where the dividend was paid out. This is primarily because of when the first payment was scheduled, on June 5.
If we were to make the rough assumption that the company's first-quarter dividend would be the same as the second quarter, then we'd see a company that's brought in $16.5 million in free cash flow over the first 12 months, but paid out $20.6 million. That has unsustainability written all over it.
And though I think the company is on to something with its Mariano's Fresh Market concept, I think Roundy's could very likely head the same way as fellow grocer SUPERVALU
Finally, we've got RadioShack. A quick glance at many financial pages would tell you that the company has a 25% dividend yield! Yup, that's right: 25%.
There's one problem with this, though: The company has already announced that after 25 consecutive years of payouts, it is suspending its dividend. While some investors think the resignation of CEO Jim Gooch could signal a turnaround for the company, beginning investors should always be sure to double-check a company's dividend payment, as RadioShack's no longer exists.
A better way
For investors seeking a different dividend strategy, I suggest checking out our special free report: "Secure Your Future With 9 Rock-Solid Dividend Stocks." Though I no longer consider myself primarily a dividend investor, I own one of these stocks as a cornerstone of my own retirement portfolio. To see the list of all nine stocks, get your copy of the report today, absolutely free!
Fool contributor Brian Stoffel does not own shares of any companies mentioned. The Motley Fool owns shares of SUPERVALU. The Motley Fool has sold shares of RadioShack short. Motley Fool newsletter services have recommended buying calls on SUPERVALU. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.