3 Reasons a Dividend Stock Could Worry Investors

There are few events more satisfying to a stock investor than a dividend payment. In a sense, it's a reward for our good judgment, and tangible proof that we've made a solid investment decision.

But, just like the companies that pay them out, all dividends are not created equal. Some are pushed through despite serious weaknesses in a company's underlying fundamentals. How can you tell if some of your dividend-paying stocks have rotten foundations? Three of our analysts give their thoughts on what they consider to be ominous warning signs.

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Sean Williams: Dividends are the foundation to which great dividend portfolios are built, but some dividends are downright dangerous. Personally, I can't think of anything more worrisome than debt-financed dividend payments, which is akin to putting to cart before the horse.

Take biotech company Theravance as a perfect example. In 2014 Theravance split into two entities: a royalty company that retained the Theravance name and housed the company's COPD and asthma assets that were being co-developed with GlaxoSmithKlineand Theravance Biopharma, which was primarily comprised of its other non-respiratory clinical-stage compounds. Shortly before splitting, Theravance announced that it would be instituting a $0.25 per share quarterly dividend, and initially financed that dividend with a $450 million debt offering. The idea being that Theravance's next-generation products would easily finance its dividend.

The problem? Theravance's Food and Drug Administration-approved COPD and asthma compounds (specifically Breo Ellipta) haven't sold as well as expected, and they've had difficulty gaining insurance coverage. In Theravance's Q2, it only generated $13.9 million in royalties from GlaxoSmithKline, leading to a net loss of $0.07 per share. All the while, Theravance's cash and cash equivalents continue to sink due to its dividend payment and ongoing losses.

Long story short, debt-financed dividends can be time bombs just waiting to go off. If a company you own issues debt just to make a dividend payment to investors, my suggestion is to be skeptical.

: One thing that should absolutely make investors shiver is an excessively high cash dividend payout ratio.

Cash dividend what what?

Basically, this figure is akin to the payout ratio (dividends paid divided by earnings), except that free cash flow is used instead of earnings.

Basically, FCF is the monies a company has on hand for expenses like dividends. So, logically, this figure should comfortably exceed the total dividend payout.

Let's look at an example or two. Apple has very quickly increased its distribution from an initial $0.39 per share in 2013 to $0.52. Yet thanks to very strong performance, the company's cash dividend payout ratio has actually declined lately to a sound 22%.

On the flip side, we have World Wrestling Entertainment . This profligate firm loves to pay dividends. But in the late 2000s and early 2010s, its cash dividend payout ratio shot into unsustainable territory well above 100%. It wasn't much of a surprise, then, when the firm slashed its dividend by 67% in 2011.

The cash dividend payout ratio isn't a commonly used metric, but it's easy enough to calculate from a company's cash flow statement. If that calculation approaches or exceeds 100%, be afraid. Be very, very afraid.

: All too often, what seems to be a solid dividend stock turns out to be a victim of changing conditions in its industry. If the profitability of a given business model disappears, then your stock's dividend payments can disappear with it.

The best recent example is the energy industry, where oil and gas exploration and production companies have had to deal with the huge disruption of plunging prices for the energy products they drill. When crude oil prices were above $100 per barrel, companies had more than enough cash flow -- both to reinvest into drilling new wells for expanding production growth and to return to shareholders in the form of dividends. Yields on several energy stocks were extremely attractive, and capital appreciation added to total returns. Yet when oil plunged below $50 per barrel, many companies had to cut or even suspend dividends entirely in order to preserve cash to get through the hard times.

The casino industry is another place where dividends are coming under pressure. During the good times in the Asian gaming capital of Macau, soaring revenue produced greater profits and led many casino stocks to boost their payouts, either by raising regular quarterly dividend payments or by declaring special dividends from time to time. Now that Macau is suffering, some fear that dividend cuts could come if the area doesn't rebound soon.

Any dividend is potentially vulnerable to tough times in their industries. Smart investors look for stocks that have already weathered cyclical downturns and have managed to sustain or grow their dividends regardless.

The article 3 Reasons a Dividend Stock Could Worry Investors originally appeared on Fool.com.

Dan Caplinger owns shares of Apple. Eric Volkman owns shares of World Wrestling Entertainment. Sean Williams has no position in any stocks mentioned. The Motley Fool recommends and owns shares of Apple. Try any of our Foolish newsletter services free for 30 days. 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 Motley Fool has a disclosure policy.

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