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Amid the market’s mess, many pundits have touted the benefits of dividend paying stocks.

While it’s true that dividends bring you a form of income, does it really put a floor under a stock? The argument is pretty simple. Many companies have products that are such an integral part of day-to-day life that they are…

1. Very unlikely to disappear.
2. They’ve built up balance sheets that are strong enough to survive a multi-year downturn.

So instead of high share price appreciation, they repay their shareholders by passing along the profits in the form of dividends.

However, as cash flows dry up, companies cannot always support their dividends and investors can suffer a second whammy as the dividend gets cut and the stock finds a new level at the same yield.

Here’s the way to do it…

Follow The Cash

You have to be tactical. Buying dividend stocks in this type of prolonged downturn does provide a good return if the stock remains stable. But if a cash flow shock occurs, dividends could suffer and the stocks that were supported at the beginning of the bear market substantially underperform later on.

You can avoid this trap by looking at the key driver of dividends – cash flow.

In the heat of a bear market, investors will always be concerned about how far top-line growth can drop, but good management teams can handle this by cutting expenses.

However, the fixed depreciation of hard assets that are stuck to the balance sheet can make profit look worse than cash flow. While profit may look bad in the short-term, I have never seen a company cut a dividend that was 50% of free cash flow (or less).

The bottom line is that as long as free cash flow holds up, the management team has options and the dividend will be safe.

The last thing a company with a historically stable dividend will do is cut its dividend, as it would entirely change the shareholder base by boxing out value investors that have a yield hurdle.

So when it comes to dividend-paying stocks, while revenue and earnings growth are obviously important, be more concerned with the money on the cash flow statement.

Source: Beware The Dividend Trap… Here’s The Most Important Number You Should Consider