10 Dow Dividend Stocks Fail 'Acid Test'

NEW YORK (TheStreet) -- When the Federal Open Market Committee reaffirmed its target interest rate of 0% to 0.25%, it sent the yield on the 10-year Treasury note down to a meager 2.55%. As a result, the dividend yields on large-cap stocks have become a tempting alternative to fixed-income securities, but investors should not blindly assume the risks of equities for enhanced yield.

In the past, we have suggested that income investors periodically subject their portfolio to a "Dividend Acid Test*" -- a pass/fail exam that indicates if a company's dividend payout is covered, in full, by the company's liability adjusted cash flow yield (LACFY**).

Explanation of LACFY >>

Of course, a failing grade does not ensure that a dividend cut or elimination is imminent, but rather, that the failed company may have difficulty continuing payouts in the face of operational adversity or a large debt maturity. Similarly, a passing grade offers no guarantee that a company will not face a prolonged hardship or that the company's management will sustain its current dividend policy. Investors must always be cautious.

Of the 30 stocks that comprise the Dow Jones Industrial Average, 29 issues currently offer a dividend (Cisco(CSCO), the one absent issue, plans to offer a dividend in July 2011), and 18 issues pass our most stringent acid test (using 10-year average cash flow data).

However, a truly cautious investor also may wish to consider one additional criterion: The effective tax rate paid by each respective company.

As Benjamin Graham states in The Intelligent Investor, "Certain companies which have had large losses in the past have been able to report future earnings without charging the normal taxes against them, in that way making a very fine profits appearance indeed -- based paradoxically enough on their past disgraces."

Additionally, government tax subsidies may further distort the future earnings power of a corporation.

Considering the above facts, it should not comes as a surprise that the relative tax rate of Dow components differed by as much as 1,100%, averaged over the last five years. Investors seeking to preserve principal would be wise to consider the entire financial picture of a company before committing capital.

As a starting point for your research, the following pages contain pass/fail results for 28 of the 30 companies that comprise the Dow Jones Industrial Average -- ranked in ascending order by liability adjusted cash flow yield.

*Pass = Dividend yield less than LACFY, Fail = Dividend yield greater than LACFY

**LACFY is defined as: 10-Year Average Free Cash Flow / (((Outstanding Shares + Options + Warrants) x (Per Share Price) + (Liabilities)) - (Current Assets - Inventory))

Note: Insurance companies cannot be valued using a simple cash flow formula -- as a result -- Travelers has been omitted from this list. The five-year tax rates used in this story reference Morningstar tax data from 2005-09.