Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as Corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.

Let's take a look at how Penn West Petroleum (NYSE: PWE) stacks up in four critical areas, to see whether it's a dividend dynamo or a disaster in the making.

1. Yield
First and foremost, dividend investors like a large yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.

Penn West yields 4%, which is much more substantial than that of its dividend-paying peer average of 0.8%.

2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company pays out in dividends to the amount it generates. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford.

Penn West's payout ratio is 262%, which means the company pays out nearly two dollars in dividends for every dollar in net income. The story appears even worse when we examine the company's free cash flow payout ratio, since Penn West didn't generate any free cash flow over the past year. But it's important to put these numbers in context – the company has lumpy earnings, and enormous capital expenditures depressed its free cash flow. The company could sustain its current payout level, but only if earnings improve.

3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The interest coverage ratio indicates whether a company is having trouble meeting its interest payments -- any ratio less than 5 is a warning sign. Meanwhile, the debt-to-equity ratio is a good measure of a company's total debt burden.

Let's examine how Penn West stacks up to its peers:


Interest Coverage Ratio

Debt-to-Equity Ratio

Penn West Petroleum



Sandridge Energy (NYSE: SD)



Petrohawk Energy (NYSE: HK)



Chesapeake Energy (NYSE: CHK)



Average Oil & Gas Exploration and Production



Source: Capital IQ, a division of Standard & Poor's. Averages are the median of medium- and large-cap U.S. and Canadian industry components.

With an interest coverage ratio of 0.2, it might appear that Penn West is struggling to manage its debt burden. However, that figure doesn't tell the full story, because operating income was almost non-existent over the past year. Penn West's debt-to-equity ratio of 34% suggests a reasonable overall level of debt.

4. Growth
A large dividend is nice; a large, growing dividend is even better. To support a rising dividend, we also want to see earnings growth.

Penn West's earnings have shrunk 32% annually, while its dividend has grown by an average of 5% annually over the past five years. (The respective average industry figures are 0% and 4% growth.)

The Foolish bottom line
Penn West exhibits a few yellow flags -- high payout ratio and low interest coverage – that upon closer inspection turn out to be based on low earnings. The company's payout is not sustainable at current earnings levels, so dividend investors will want to keep an eye on whether profits bounce back over the next few years.

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Ilan Moscovitz doesn't own shares of any company mentioned. Motley Fool Alpha LLC owns shares of Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.