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, 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 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 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 Archer Daniels Midland (NYSE: ADM).

What's on the surface?
Archer Daniels Midland, which operates in the agricultural products industry, currently pays a dividend of 1.9%. That dividend yield may not seem like much, but considering that more than 100 companies in the S&P 500 don't pay anything at all, it's nothing to complain about. Plus, don't forget that dividends typically grow with time, so that 1.9% has the potential to skyrocket.

But more important than the dividend itself is Archer Daniels Midland's 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. Archer Daniels Midland 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 is 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, Archer Daniels Midland's payout ratio is 19.3%. At least on the surface, it's obvious that Archer Daniels Midland has no problem generating enough income to support that nice dividend of 1.9%.

Now that we've checked out the payout ratio, let's take a peek at Archer Daniels Midland'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, which is cash flow per share divided by dividends per share. Normally, anything greater than 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. Archer Daniels Midland's coverage ratio is 2.89, -- which is more than enough cash on hand to keep pumping out that 1.9% 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 Archer Daniels Midland's closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Archer Daniels Midland 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 Archer Daniels Midland stacks up below:

Company

Dividend Yield

Payout Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

Archer Daniels Midland

1.9%

19.3%

2.89

12.6%

Kraft Foods (NYSE: KFT)

3.8%

46.2%

1.32

7.2%

Kellogg (NYSE: K)

3.2%

45.5%

2.08

8.2%

HJ Heinz (NYSE: HNZ)

3.8%

61%

1.99

8.2%

ConAgra Foods (NYSE: CAG)

3.7%

47.8%

2.85

-6%

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 Archer Daniels Midland'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.

Jordan DiPietro owns no shares of any company mentioned above. H.J. Heinz and Kellogg are Motley Fool Income Investor recommendations. Try any of our Foolish newsletter services free for 30 days. True to its name, The Motley Fool is made up of a motley assortment of writers and analysts, each with a unique perspective; sometimes we agree, sometimes we disagree, but we all believe in the power of learning from each other through our Foolish community. The Motley Fool has a disclosure policy.