How Safe Are DuPont's Dividends?

Whether you're a beginning investor or a near-retiree, the importance of purchasing stocks that pay dividends cannot be overstated. Companies with 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. That is an incredible difference -- one that you'd be crazy to not 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 if a company's unlikely to continue paying its dividend. Today, let's see whether any of these red flags currently fly over DuPont (NYSE: DD).

What's on the surface?
DuPont, which operates in the diversified chemicals industry, currently pays a dividend of 4.07%. That's certainly nothing to sneeze at, since the average dividend payer in the S&P 500, in 2009, sported a yield of 2%.

However, DuPont's ability to keep that cash rolling is even more important than the dividend itself. To ensure its payout won't wear out, first 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, you may have spotted an initial signal that something just isn't right. Check out the graph below for details of the last five years:

Clearly, there doesn't seem to be a problem, here. DuPont 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 a company's net income gets paid out to investors in the form of a dividend. Normally, anything greater than 50% is cause for further scrutiny. According to the most recent data, DuPont's payout ratio is 47.64%. It's obvious that, at least on the surface, there aren't any problems with DuPont generating enough income to support that nice dividend of 4.07%.

Beyond the payout ratio, we'll need to peek at DuPont's cash flow. Businesses 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 check the strength of this current of cash, we can use a simple metric called the cash flow coverage ratio, which is 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. DuPont's coverage ratio is 2.14, -- more than enough cash on hand to keep pumping out that 4.07% 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 DuPont's closest competitors and comparably diversified companies. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If DuPont 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 DuPont 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, DuPont's payout ratio seems to be just below the peer average, which means if you're a prudent investor, you should feel pretty confident in DuPont's dividend. But whether you're studying a dividend, a share repurchase, or an ordinary earnings report, you always need to do your own due diligence. Looking at all of the numbers in the best context possible is just the best place to start.