It's been a scary crisis for dividend investors.

Even after the subsequent rally, a lot of dividend yields are sky-high. According to Capital IQ, there are 806 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 and then another 10% from 2009 to 2010. 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 3.8% yield, but its sustainability is seriously threatened by stiff and strengthening competition in the mobile handset space. Like Harley-Davidson, PNC's 0.8% dividend yield is almost immaterial.

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:

Company

Dividend Yield

Payout Ratio

Pitney Bowes (NYSE: PBI) 6.7% 88%
Royal Dutch Shell (NYSE: RDS-B) 5.1% 67%
Lorillard (NYSE: LO) 5.3% 63%
Verizon (NYSE: VZ) 6.0% 1,227%

Source: Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

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 four companies listed above), I get suspicious. When the payout ratio goes above 100%, a company's earnings aren't enough to cover its dividends (Verizon).

Worse than a payout ratio greater than 100% is a negative ratio -- it means the company is paying out dividends despite reporting a loss (fortunately, that's none of these companies).

I would certainly take a good hard look at the earnings quality of the four companies above with payout ratios greater than 50% (or any company, for that matter).

Now, keep in mind that the payout ratio is just one metric. It's useful for screening purposes, but further research fills in the picture. For instance, those making the bull case for Verizon would say the company's payout ratio looks so cartoonish because of restructuring charges hitting the income statement. However, Verizon's hefty free cash flow easily covers its dividend.

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. Be careful out there.

If you'd like some help constructing your own portfolio -- including some sustainable dividend plays -- check out our Million Dollar Portfolio service. Our analysts construct a real-money portfolio of the "best of the best" of the Motley Fool's newsletters. Just enter your email address in the box below to get started.

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

Anand Chokkavelu owns shares of Harley-Davidson. In his spare time, he hosts a snack-food program called These Doritos Are Done. Nokia is a Motley Fool Inside Value choice. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.