Cramer: Not All Dividends Are Safe

By now most Mad Money viewers should know how adamantly Cramer’s been recommending dividend-paying stocks.

The way he sees it, a nice yield provides a much-needed cash cushion in this volatile market. Plus, as a stock drops, the yield it pays increases, attracting more investors to it. The new buyers then buoy the stock from falling too far. And, hey, if the stock goes up in price, investors can win that way, too. The strategy’s been working in names like Nucor, BB&T, Kinder Morgan Energy Partners and others.

But don’t be fooled by big-number dividend yields. That was part of Cramer’s focus for Wednesday. Just because the payout looks juicy doesn’t necessarily mean that it is. Companies have been slashing their dividends to hoard cash in this tough market. So investors have to do the due diligence necessary to make sure the companies they’re buying can sustain those dividends.

So how do you know when a dividend is safe? Cramer recommended looking at three key factors: earnings, cash flow and balance sheet. Let’s compare recent dividend increases by Verizon Communications and Masco using these three guidelines.

Verizon just bumped its quarterly dividend up to 46 cents a share. That’s great and all, but that puts the company’s annual earnings at only 1.4 times that payout. Historically, companies in the S&P 500 has paid out about 50% of their earnings in dividends, Cramer said, so he’d rather see VZ’s earnings be at least twice the dividend. That’s his rule: earnings that are twice the dividend.

But while the earnings metric might not work for Verizon, the cash flow test does. For the past four quarters, the company’s free cash flow was 60% higher than its reported income. So while earnings might not measure up to Cramer’s standard, there seems to be enough money floating around at Verizon to cover the dividend.

Masco, however, just doesn’t work. Despite boosting its dividend for the past 50 years, Cramer doubts the company will be able to maintain the payout through 2009 and 2010. The annual dividend is up to 94 cents a share, 23.5 cents a quarter, but Masco’s earnings haven’t reached that level for the past four quarters. And analysts expect the company to make less than 94 cents a share for the next two years. So while that 9.3% yield looks good, Cramer’s betting Masco might have to cut it at some point in the near future.

Masco’s been saying that free cash flow will allow them to pay the dividend, but the company’s only generating that money by delaying its bill payments and demanding earlier payments from its customers. That’s not a sustainable business model. Plus, the $1 billion in cash on the balance sheet is easily overshadowed by the $4 billion in debt.

Cramer’s take: Masco, especially since its levered to housing, should be focused on conserving cash, not boosting its dividend. Verizon, on the other hand, is worth a look by any investor.

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