How Long Can Virgin Media's Dividends Last?

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 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 Virgin Media (Nasdaq: VMED).

What's on the surface?
Virgin Media, which operates in the cable and satellite industry, currently pays a dividend of 0.63%. That dividend yield may not seem like much, but considering that over 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 0.63% has the potential to skyrocket over time.

But what's more important than the dividend itself is Virgin Media'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.

Wow -- something just isn't right here. Clearly, Virgin Media has kept its dividend despite losing money in each of the past several years, and investors should proceed with caution. It's possible that there may be reason for this, so let's look further to see how much trouble we're actually in.

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, Virgin Media's payout ratio is not available because of its negative earnings. This isn't necessarily a bad thing -- companies can keep paying dividends even if they lose money from time to time. What's important is if there's enough cash on hand to support that high payout ratio, so let's look at free cash flow.

Free cash flow -- all the cash left over after subtracting out capital expenditures -- is used by firms 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. Virgin Media's coverage ratio is 11.21, which is more than enough cash on hand to keep pumping out that 0.63% 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 Virgin Media's closest competitors. Check out how Virgin Media 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 mean additional risk. However, in this situation, Virgin Media's coverage ratio seems to be above the peer average, which means if you're a prudent investor, you will probably be pretty comfortable with this dividend. 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.