Paychex: Dividend Dynamo or Disaster?

Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.

Let's examine how Paychex (Nasdaq: PAYX) stacks up in four critical areas to determine whether it's a dividend dynamo or a disaster in the making.

1. Yield
First and foremost, dividend investors like a large yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.

Paychex yields 5% -- fairly high but not necessarily cause for alarm.

2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends to the amount it generates. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford.

Paychex's earnings payout ratio is 94%; if we consider free cash flow, that figure is 82%. This appears somewhat high, though that's partially a function of Paychex's depressed net income over the past year.

3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The interest coverage ratio indicates whether a company is having trouble meeting its interest payments -- any ratio less than five is a warning sign. Meanwhile, the debt-to-equity ratio is a good measure of a company's total debt burden.

Paychex doesn't carry any debt.

4. Growth
A large dividend is nice; a large growing dividend is even better. To support a growing dividend, we also want to see earnings growth.

Let's examine how Paychex stacks up next to its peers:

Source: Capital IQ, a division of Standard & Poor's. Median is of medium- and large-cap U.S. industry components.

Of the 14 major data processors, only four (Paychex, ADP, Alliance Data Systems (NYSE: ADS), and Total System Services (NYSE: TSS)) have dividend histories spanning at least five years. (Paychex instated its dividend in 1988.)

The Foolish bottom line
Paychex exhibits a fairly clean dividend bill of health. The only concern is its high payout ratio, which could limit future dividend growth to at or below its earnings growth rates. But especially given Paychex's balance sheet strength, it can maintain its current payout while we wait for earnings to recover.