10 High-Yielding Stocks With Risky Dividends

A juicy stream of dividend income is appealing—especially during a bear market. The danger is that what may seem appealing on the surface can have signs of rot at its core.

One of the ways to ensure a stock is ripe for being added and not at risk of spoiling your portfolio is to see how well the dividend is being covered. A popular way of doing this is to analyze the earnings payout ratio. A better way is to also look at the free-cash-flow payout ratio. On both measures, the 10 stocks listed below would have Mr. Whipple cringing, just as he would if somebody were squeezing the Charmin.

The earnings payout ratio is dividends per share divided by earnings per share. It shows you the extent to which 12 months of dividends are “covered” by 12 months of earnings. The further below 100% this ratio is (though staying positive), the greater the margin by which earnings exceed the dividend.

Earnings, however, are not cash. Income and expenses are reported irrespective of whether cash has been paid or received when accrual accounting is used. This can lead to situations when earnings are positive but cash flow (actual cash flowing in and out of the corporation) is negative.

To get around this problem, we take the free-cash-flow payout ratio into consideration when analyzing stocks for the AAII Dividend Investing (DI) portfolio.

Free cash flow shows how much cash a company has for discretionary spending. As DI editor Derek Hageman recently explained, “free cash flow is calculated by deducting capital expenditures (capex) from cash from operations. Cash from operations tries to look into the cash inflows and outflows caused by the core business operations and, in turn, the cash generated by the company’s products and services. Capex are funds used by a company to acquire, upgrade and maintain physical assets such as property, industrial buildings or equipment. Capex is often used by a firm to undertake new projects or make investments.

“What’s the purpose of deducting capex from cash from operations? Cash from operations offers an idea of how much cash a company’s day-to-day operations have generated. However, for a company to grow, it must also reinvest in itself to maintain operations as well as expand them. While skimping on capex is a way to save money in the short term, in the long run it is a surefire way to inhibit growth. This definition of cash flow describes a pre-dividend free-cash-flow figure. The residual cash amount indicates whether a company is generating enough cash from its normal business operations to fund its capital expenditures and still have money available to pay a dividend, retire debt, buy back shares or make acquisitions.”

The free-cash-flow payout ratio therefore analyzes how much cash a company is paying in dividends as a percentage of free cash flow. The ratio should be positive (the company is bringing more cash than it is spending) and below 100%. If it isn’t, then the dividend may not be sustainable.

Yields are often adjusted to reflect concerns about the dividend not being sustainable. Investors and traders demand a higher yield now as compensation for the possibility of the dividend being cut or suspended in the future. The greater the perceived risk, the higher the yield demanded.

The 10 stocks below are examples of this. Their high yields reflect concerns about their ability to maintain the current dividend payments. As you look at them, realize that any additional weakness in the economy could create more strain on the companies underlying these stocks. It’s a reminder that while high yields may be tempting, you should take care to ensure the dividend isn’t at risk of turning from juicy to rotten.