Whether you're a beginning investor or a near-retiree, you can't overstate the importance of purchasing stocks that pay dividends. Not only do companies that have quarterly or annual payouts provide you with a steady stream of income, but they also hold 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 didn't pay dividends earned an average annual return of 4.1%, while dividend stocks 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 to look for, and any of them could be the crucial factor in determining whether a company is likely to continue paying its dividend. Today, let's drill down into ITT (NYSE: ITT).

What's on the surface?
ITT, which operates in the aerospace and defense industry, currently pays a dividend of 2.20%. That's certainly nothing to sneeze at, consider the average dividend payer in the S&P 500 sported a yield of 2.0% in 2009.

But what's more important than the dividend itself is ITT'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, that may be an initial red flag. Check out the graph 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. ITT has been able to boost its earnings at an adequate pace and keep its dividends rolling 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 goes 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, ITT's payout ratio is 32.35%. It's obvious that, at least on the surface, ITT doesn't face any trouble generating enough income to support that nice 2.20% dividend.

More important than checking out the payout ratio may be simply taking a peek at ITT's cash flow. Companies use free cash flow -- all the cash left over after subtracting 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 above 1.2 should make you feel comfortable; anything less, and you may have a problem on your hands. ITT's coverage ratio is 4.70, so it has more than enough cash on hand to keep pumping out that 2.20% yield. Barring any unforeseen circumstances, there shouldn't be any major problems moving forward.

Either way, it's always beneficial to compare an investment with its competitors. In the table below, I've included the above metrics with those of ITT's closest competitors. I've also included the five-year dividend-growth rate, which is another important indicator. If ITT 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 ITT stacks up:




Coverage Ratio

5-Year Compounded Dividend Growth Rate






Honeywell International (NYSE: HON)





Raytheon (NYSE: RTN)





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

The Foolish bottom line
In the end, only you can decide what numbers you're comfortable with. Sometimes a higher yield and a higher reward mean additional risk. However, in this situation, ITT's payout ratio seems to be above the peer average, so if you're a prudent investor, you may want to look elsewhere for the most secure payment possible. The bottom line 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 the best place to start.