Darden's Dividends May Not Last Forever

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Not only do companies that have quarterly or annual payouts provide you with a steady stream of income, but they 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. That's an incredible difference -- one you'd be crazy not to take advantage of!

But investing in dividends can be dangerous. Companies can cut, slash, or suspend dividends at any time, often without notice. Fortunately, there are several warning 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 Darden Restaurants (NYSE: DRI).

What's on the surface?
Darden Restaurants currently pays a dividend of 2.74%. That's certainly nothing to sneeze at, since the average dividend payer in the S&P 500 sported a yield of 2% in 2009.

But Darden Restaurants's ability to keep that cash rolling is even more important than the dividend itself. Start by looking 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. Darden Restaurants has been able to boost its earnings at an adequate pace, and keep its dividends in check at the same time.

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. This number tells you what percentage of net income gets paid out to investors in the form of a dividend. Normally, anything greater than 50% is cause to look a bit further. According to the most recent data, Darden Restaurants' payout ratio is 35.36%. It's obvious that, at least on the surface, there aren't any problems with Darden Restaurants generating enough income to support that nice dividend of 2.74%.

Once you've checked out the payout ratio, try taking a peek at Darden Restaurants' 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!

To measure this metric, we can use 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. Darden Restaurants' coverage ratio is 3.31, -- which is more than enough cash on hand to keep pumping out that 2.74% yield. Barring any unforeseen circumstances, there really shouldn't be any major problems moving forward.

Either way, it always helps to compare an investment with its most immediate competitors. In the chart below, I've included the above metrics with those of Darden Restaurants' closest rivals. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Darden Restaurants can illustrate that it's grown dividends over the past five years, then there's a good chance that it will continue to put shareholders first in the future. Check out how Darden Restaurants 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, in this situation, Darden Restaurants's payout ratio seems to exceed the peer average. If you're a prudent investor interested in this group of dividend payers, you may want to look elsewhere. However, a 35% payout certainly is pretty reassuring.

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.