How Safe Are Inergy's Dividends?

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 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 warning 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 Inergy (NYSE: NRGY).

What's on the surface?
Inergy, which operates in oil and gas storage and transportation, pays a dividend of 7.43%. That's certainly nothing to sneeze at, because in 2009, the average dividend payer in the S&P 500 sported a yield of 2%.

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

Wow, something just isn't right here. Clearly, Inergy has been boosting its dividend at a rate that is far above that of its reported earnings, 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, Inergy's payout ratio is 274.47%. Inergy is obviously paying out more than its net income in the form of a dividend. High payouts aren't always a bad thing -- companies can increase their payout ratios over time, possibly because they are becoming more mature, or possibly because that's the best way to increase shareholder value. Here, though, it's pretty extreme. 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 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. Inergy's coverage ratio is 0.16, which is so low that it makes me very uncomfortable as an investor. There could be a number of reasons the number is so low -- maybe it's typical for the industry, maybe there's a significant amount of debt coming due, or maybe Inergy is simply less than stellar at managing its assets.

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 Inergy's closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If Inergy 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 Inergy 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, Inergy's payout ratio looks to be way above the peer average, which means if you're a prudent investor, you may want to look elsewhere for the most secure payment possible. 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.