How Safe Are General Mills' Dividends?

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Companies that have quarterly or annual payouts not only provide you with a steady stream of income, but also have the potential for capital appreciation. Simply put, dividend stocks can you give your portfolio what almost no other investment can -- both income and growth.

At The Motley Fool, we're avid fans of dividends -- and not just because we like that steady stream of cash. Studies have shown that from 1972 to 2006, stocks in the S&P 500 that don't pay dividends have earned an average annual return of 4.1%; dividend stocks, however, have averaged a whopping 10.1% per year. You'd be crazy not to take advantage of that incredible difference!

But investing in dividends can be dangerous -- companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warnings signs that may alert you, and these red flags could be the crucial factor in determining whether or not a company is likely to continue paying its dividend. Today, let's drill beneath the surface and check out General Mills (NYSE: GIS).

What's on the surface?
General Mills, which operates in the packaged foods and meats industry, currently pays a dividend of 3.15%. That's certainly nothing to sneeze at, since 2009's average dividend payer in the S&P 500 sported a yield of 2%.

But what's more important than the dividend itself is General Mills' ability to keep that cash rolling. The first thing to look at is the company's reported dividends versus its reported earnings. If you happen to see dividend payments that are growing faster than earnings per share, it may be an initial signal that something just isn't right. Check out the graph below for details of the last five years:

Source: Capital IQ, a division of Standard & Poor's.

Clearly, there doesn't seem to be a problem here. General Mills has been able to boost its earnings at an adequate pace while keeping its dividends in check.

The more secure, the better
One of the most common metrics that investors use to judge the safety of a dividend is the payout ratio. It tells you what percentage of net income is paid out to investors in the form of a dividend. Normally, anything above 50% is cause to look a bit further. According to the most recent data, General Mills' payout ratio is 42.06%. At least on the surface, the company should have no problem generating enough income to support that nice dividend of 3.15%.

Now that we've checked out the payout ratio, let's peek at General Mills's cash flow. Firms use free cash flow -- all the cash left over after subtracting out capital expenditures -- to make acquisitions, develop new products, and of course, pay dividends! We can use a simple metric called the cash flow coverage ratio: cash flow per share divided by dividends per share.

Normally, anything above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. General Mills' coverage ratio is 2.48, which leaves more than enough cash on hand to keep pumping out that yield. Barring any unforeseen circumstances, there really shouldn't be any major problems moving forward.

Either way, it's always beneficial to compare an investment with its most immediate competitors. In the chart below, I've included the above metrics with those of General Mills' closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If General Mills can illustrate that it's grown dividends over the past five years, there's a good chance that it will continue to put shareholders first in the future. Check out how General Mills stacks up below:

Source: Capital IQ, a division of Standard & Poor's.

The Foolish bottom line
Only you can decide what numbers you're comfortable with in the end; sometimes a higher yield and a higher reward means additional risk. However, when we look at General Mills's payout ratio compared to its peer average, we see that it is a lower percentage, which illustrates that its dividend is probably more sustainable. The bottom line, however, is to make sure that with anything -- whether it be a dividend, a share repurchase, or an ordinary earnings report -- you do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.