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Dividend paying stocks often outperform the broader market during times of economic or stock market uncertainty, like the past few months with turmoil in Europe and stock market declines in the United States. The stable dividend paying stocks such as Procter & Gamble (PG), Johnson & Johnson (JNJ), and Microsoft (MSFT) have steadily-increasing dividends and virtually no short-term risk of reducing them. However, dividend-paying stocks are all too often lumped into a single category, without enough attention being placed on the quality of the dividend or the likelihood that it will be able to be maintained into the future.

Companies are often loathe to reduce or eliminate dividends, even when prudent for the business to do so, out of the (typically founded) fear that an entire class of investors and mutual fund managers that invest in dividend-paying stocks will reduce or eliminate their holdings in the event of a dividend reduction. Stocks with unsafe dividends are particularly risky for independent investors because they often appear attractive or pass stock screeners. It is therefore necessary to use metrics to understand the relative safety of the dividends of these companies.

A key metric that provides insight into the long-term safety of a dividend is the payout ratio. The payout ratio takes the dividend and divides it by (typically) the last 12-months of earnings. This is most often expressed on a percentage basis, i.e. 100%. If a stock has a payout ratio below 100%, that denotes that the company has paid out a lower amount than the profit it earned during the period. If the payout ratio is above 100%, then it indicates that the company paid out more in dividends than it earned during the period. Most conservatively run companies with growth prospects seek to have dividend payouts well below 50%. (Companies with lesser growth prospects or real estate investment trusts will sometimes have far higher payout ratios; 90% or greater payout ratios are mandated by IRS rules in the case of REITs). Below, 3 stocks with potentially unsafe dividends are presented. When assessing these and other stocks for investment, investors are encouraged to use payout ratios to be able to ascertain whether firms have the wherewithal to make future dividend payments.

Educational Development Corporation (EDUC): The maker of children's books and educational materials has been on a slow decline for many years, with reduced profits and revenues falling each year dating back to 2008. The quarterly dividends amount to .48 annually and represent a 10.7% annual dividend, which may appear appealing to investors. However, the payout ratio is well over 100% at 133%, which calls into question how the company will pay for future dividends. Fully diluted earnings per share have fallen from .60 in 2007 to .36 in 2012. Investors should either price in a major reduction to future dividends from EDUC or forecast significant earnings growth to account for future dividend payments. Unfortunately there is relatively little cash remaining on the balance sheet to support future dividend payments.

Ship Finance Limited (SFL): This ocean-going vessel owner and leasing firm pays quarterly dividends amounting to $1.56 annually. However, diluted earnings have fallen from $2.60 to $1.70 over the past three years, while the dividend has increased slightly. The payout ratio of 86% provides very little room for further reductions in earnings per share. SFL has $1.71 per share of cash remaining on the balance sheet but significant debt service, which leaves relatively little cushion to support the existing dividend if profits continue to slide.

Verizon (VZ): This mammoth $122 billion market capitalization integrated communications firm has been an excellent performer, and is presently trading near its 52-week high in a long sustained run since July of 2010. However, it makes our list of unsafe dividend investments due to its excessive payout ratio of 210%. While it has steadily increased its quarterly dividends to $2.00 per share annually, it has consistently paid a dividend that exceeds its profitability. While firms can utilize cash flow and leverage on their balance sheets to make these payments over the short run, it is a highly risky strategy for dividend investors to invest in firms like Verizon that have payout ratios well over 100%.

Source: 3 Stocks With Unsafe Dividends