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 take a close look at Holly (NYSE: HOC).

What’s on the surface?
Holly, which operates in the oil and gas refining and marketing industry, currently pays a dividend of 2.17%. That's nothing to sneeze at, considering 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 Holly'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.

Wow -- something just isn't right here. Clearly, Holly has been maintaining its dividend at a rate far above that of its reported earnings, and investors should proceed with caution. Let’s look further to see how much trouble we're actually in with this company.

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, Holly's payout ratio is 147.27%. That's a substantial number, but it isn't necessarily a bad thing. Companies can increase their payout ratios over time -- sometimes because the companies are becoming more mature, and other times because a larger payout represents the best way to increase shareholder value. What's important is whether there's enough cash on hand to support that high payout ratio, so let's look at free 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. Holly's coverage ratio is -3.54, and that figure doesn't make me feel comfortable as an investor. There could be several reasons the number is so low -- maybe this is a typical range for the industry, maybe there's a significant amount of debt coming due, or maybe Holly is simply less than stellar at managing its assets.

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 Holly's closest competitors. I've also included the five-year dividend-growth rate, which is another important indicator. If Holly 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 Holly stacks up:




Coverage Ratio

5-Year Compounded Dividend Growth Rate






Valero Energy (NYSE: VLO)





Sunoco (NYSE: SUN)





NuStar Energy (NYSE: NS)





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, Holly'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.

Jordan DiPietro owns no shares of the stocks 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 Motley Fool has a disclosure policy.