With the economy still shaky, many wary investors have been turning to the safety of dividend-paying stocks.

Buyer beware
While dividends provide a source of income that helps to smooth out market volatility, crises like the recent 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 in 2008, and their stock prices had an average return of negative 56% for the year.

While things have calmed down a bit, we've already had another 129 cuts already so far this year.

So how can you tell whether your company is about to make a cut? Last year, I argued that General Electric (NYSE: GE) and Calumet Energy were risking dividend cuts. (GE has since done so.) It wouldn't surprise me if GE's dividend rose again over the next few years, but given its reduced profits, I don't expect its payouts to reach the level they were at prior to its historic cut for some time.

Among the warning signs these companies exhibited:

  • High yields.
  • High payout ratios.
  • Industry headwinds.

Extremely high yields indicate investors' skepticism that the company will be able to maintain its dividend. 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.

Bank of America (NYSE: BAC), for instance, was yielding nearly 8% in October 2008 when it had to suspend its dividend to preserve capital. While conditions for the bank are expected to improve, it's going to take several more years for the company to afford that $2.56 payout again, based on analyst earnings estimates.

But these factors don't necessarily imply that a cut is imminent. Many companies have continued to pay dividends they cannot afford for years, damaging their own companies -- 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, because they wouldn't want lenders to think that their company is struggling.

Such a fear may be one of the reasons why Citigroup reluctantly slashed its dividend three times, apparently hoping each time that a limited cut would do the trick. It may also explain why Wells Fargo (NYSE: WFC) and Morgan Stanley (NYSE: MS) waited to reduce their dividends until after JPMorgan (NYSE: JPM) announced its cut.

Today, JPMorgan is again rolling in it, and could probably afford to reinstate its former dividend. Morgan Stanley and Wells Fargo could afford to pay more than they are currently.

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.

While some of these practices may be acceptable bandages 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 the business will ultimately have to cut its dividend anyway.

So which companies might fit that description today?

Two companies risking a burnout
These two stocks 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:

Company

Net Income
Payout Ratio

Free Cash Flow
Payout Ratio

Total 3-Year
Shortfall*

Funding Method

Xcel Energy (NYSE: XEL)

61%

N/A

$1.8 billion

Debt, Stock

PetroChina (NYSE: PTR)

39%

709%

$36.3 billion

Debt

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

Xcel Energy, a company that has steadily raised its dividend since 2003, hasn't produced more free cash flow than it's paid out in dividends since that year. PetroChina may have other considerations that factor in to its dividend policy -- the company is 86% owned by the Chinese government, but it's noteworthy that the company hasn't generated enough free cash flow to comfortably afford its dividend since 2005.

So should you short these stocks?
It might be tempting to conclude from these numbers that we've found two stocks worth shorting.

But it can be painful to short dividend stocks -- Xcel yields 4.4%, PetroChina 3.1% -- since you, as the short seller, are responsible for paying those dividends. Moreover, these companies have been paying out over 100% of their free cash flow levels for years. While it may not be wise policy, a cut may not be imminent.

In other words, an unsustainable dividend policy is one thing, but when shorting stocks, you want to look for other red-flags as well -- operational difficulties, weak competitive positions, and dangerous accounting shenanigans.

If you'd like to learn more about ways to spot potential ticking time bombs to protect your portfolio or profit on short ideas, enter your email in the box below to receive John Del Vecchio's, CFA, free report "5 Red Flags -- How to Find the Big Short." Del Vecchio has an impeccable record as an analyst and a money manager; most recently, he managed the Ranger Short Only portfolio from 2007 to 2010, where he outperformed the S&P 500 by 40 percentage points. John's report is free, and it's the first step toward putting powerful analytical tools to work for your portfolio.

This article was originally published March 26, 2009 under the headline "The Next 3 Dividend Burnouts?" It has been updated.

Ilan Moscovitz is neither long nor short any other companies mentioned in this article. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.