NEW YORK (CNN/Money) -
Pop quiz: What do General Motors, Philip Morris, Heinz, Eastman Kodak, Verizon and J.P. Morgan Chase have in common?
In addition to being among the most recognizable brand names in the U.S., these six stocks all sport dividend yields that are higher than the 10-year Treasury bond's yield of 4.45 percent. Indeed, more than 20 percent of S&P 500 companies now yield at least 3 percent, and the average is 2 percent -- above even the average money-market rate of 1.8 percent.
What's all this mean? Companies pay a portion of their net earnings to shareholders as dividends. As share prices have been crushed, dividend yields have jumped. For example, for each share of General Motors you own, you get $2 a year in dividends. As the stock has fallen from the mid-$60s to a recent $41, the yield -- or the return if you buy the stock -- has climbed from a little more than 3 percent to nearly 5 percent.
It could take a while for GM -- and the other beaten-up blue chips -- to reclaim lost ground. But, the theory goes, a dividend allows you the opportunity to get paid while waiting for a turnaround.
"When you get a market where there's a lot of indiscriminate selling, you can buy some pretty good companies with yields of 3 percent or more trading at reasonable valuations," says John Snyder, manager of the John Hancock Dividend Performers fund. "That's a good situation."
Make sure dividends won't get cut
It's a good theory but one that comes with a big caveat: Dividends are by no means guaranteed, and companies can cut them when they get into trouble. AT&T, for example, slashed its annual dividend in December 2000 due to its burdensome debt load. Shareholders depending on 88 cents a share in dividends were forced to accept just 15 cents -- the yield plunged from 4.6 percent to less than 1 percent.
So with concerns about earnings and balance sheet quality continuing to plague the markets, it's not enough to just look at a company's dividend yield.
One way to judge whether a company's ability to pay its dividend is sustainable is by checking a stock's payout ratio: the stock's annual dividend payment divided by earnings for the last fiscal year. The payout ratio is a measure of how much earnings a company is retaining to spend on general corporate activities such as acquisitions or research and development.
A high payout ratio is probably not a good sign. If a company is paying too much of its earnings to shareholders instead of investing in its own business, it might have to cut the dividend in the future. James Denney, manager of the Electric City Dividend Growth fund, says he generally shies away from companies with payout ratios above 60 percent.
| * As of July 22 |
| Source: Multex Investor|
With that in mind, Denney says that Verizon appears to be a good bet despite the myriad problems plaguing the telecom sector. Fellow Baby Bells SBC and BellSouth both issued earnings warnings for the remainder of the year this week.
Verizon, which reports its second quarter earnings on July 31, pays an annual dividend of $1.54 a share. The company earned $3 a share last year so its payout ratio is 51 percent. Denney owns Verizon in his fund.
SBC and BellSouth, which Denney does not own, also look relatively safe. BellSouth's yield is 3.5 percent and SBC's is 4.5 percent and both stocks have payout ratios below 50 percent.
Denney says he also sees some value in the drug sector, despite concerns about pipelines and competition from generic drug makers. Merck, for example, has a yield of 3.5 percent and its payout ratio is just 44 percent. "Merck is a company with an excellent dividend increase track record and the payout ratio is under 50 percent. Merck's dividend is clearly sustainable," Denney says. In fact, Merck announced on Tuesday that it was increasing its dividend by 3 percent. Denney also owns drug maker Schering-Plough.
But the payout ratio is not the only thing that investors should scrutinize. Bern Fleming, manger of the AXP Utilities fund, says he looks closely at a company's debt level and fundamentals and is even willing to tolerate higher payout ratios if a company has a healthy balance sheet and the ability to continually generate strong levels of earnings growth.
Fleming likes Dominion Resources and Southern Companies even though their payout ratios are higher than 75 percent. Both companies reported better-than-expected earnings growth in the second quarter and their debt-to-equity ratios are below industry averages.
Of course, this is not to say that investors should only buy stocks that pay dividends. But if recent market history has taught us nothing, it's that diversification is important. And it's certainly nice to have the security of an income-paying stock.