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 show that from 1972 to 2006, stocks in the S&P 500 that didn't pay dividends earned an average annual return of 4.1%; dividend stocks, however, 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 American Express (NYSE: AXP).

What's on the surface?
American Express, a consumer finance company, pays a dividend of 1.8%. 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, dividends typically grow with time, so that 1.8% has the potential to skyrocket.

But what's more important than the dividend itself is American Express' ability to keep that cash rolling in. 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 past five years:



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

Clearly, there doesn't seem to be a problem here. American Express 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 above 50% is cause to look a bit further. According to the most recent data, American Express' payout ratio is 26.5%. It's obvious that, at least on the surface, there aren't any problems with American Express generating enough income to support that 1.8% dividend.

More important than checking out the payout ratio may be simply taking a peek at American Express' cash flow. Free cash flow -- all the cash left over after subtracting out capital spending -- is used by companies 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 above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. American Express' coverage ratio is 8.62 -- which is more than enough cash on hand to keep pumping out that 1.8% 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, so in the chart below, I've included the above metrics with those of American Express' closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If American Express can illustrate that it has 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 American Express stacks up below:

Company

Dividend Yield

Payout Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

American Express

1.8%

26.5%

8.62

8.5%

Visa (NYSE: V)

0.8%

13.2%

3.68

N/A

Capital One Financial (NYSE: COF)

0.5%

4.6%

49.79

13.4%

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 mean additional risk. However, in this situation, American Express' payout ratio seems to be above the peer average, which means if you're a prudent investor, you may want to look elsewhere for the most secure payment possible (although it certainly doesn't look at risk here). 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 doesn't own any shares mentioned here. 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 Fool has a disclosure policy.