Whether you're a beginning investor or a near-retiree, we can't overstate the importance of purchasing dividend-paying stocks. Companies with quarterly or annual payouts not only provide a steady stream of income, but also have the potential for capital appreciation -- a rare and valuable combination.

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, non-dividend-paying stocks in the S&P 500 have earned an average annual return of 4.1%; dividend stocks, however, have averaged a whopping 10.1% per year. You'd be crazy not to take advantage of that incredible difference!

That said, investing in dividends can be dangerous. Companies can cut, slash, or suspend payouts at any time, often without notice. Fortunately, several warning signs can help you determine whether a company will likely continue paying its dividend. Today, let's drill deeper into Safeway (NYSE: SWY).

What's on the surface?

Safeway, which operates in the food retail industry, currently pays a dividend of 2.1%. That's certainly nothing to sneeze at, since the average dividend payer in the S&P 500 sported a yield of 2% in 2009.

However, Safeway's dividend itself pales in importance to the company's ability to keep that cash rolling. To figure out whether it can sustain that payout, start by comparing Safeway's reported dividends to its reported earnings. Dividend payments that are growing faster than earnings per share 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, Safeway has been boosting its dividend at a rate that far exceeds its reported earnings, and investors should proceed with caution. Still, it's possible that there may be a good explanation behind this alarming trend.

The more secure, the better
The payout ratio is one of investors' most common tools for judging a dividend's safety. This number tells you what percentage of a company's net income gets paid out to investors in dividends. Normally, anything greater than 50% merits further investigation.

According to the most recent data, Safeway's payout ratio is negative because earnings have been negative so far in 2010. This isn't necessarily bad -- companies can increase their payout ratios over time, possibly because they're becoming more mature, or possibly because higher dividends are the best way to increase shareholder value. We simply need to make sure that a company has enough cash on hand actually fund those payouts.

Safeway's cash flow may be even more important than its payout ratio. Firms use free cash flow -- the cash left over after subtracting capital expenditures -- to make acquisitions, develop new products, and of course, pay dividends!

To evaluate how well Safeway can fund its dividend, we can use a simple metric called the cash flow coverage ratio: cash flow per share, divided by dividends per share. Normally, anything greater than 1.2 should make you feel comfortable; anything less could spell toruble. Safeway's coverage ratio is 7.95, giving the company more than enough cash on hand to keep pumping out that 2.1% yield. Barring any unforeseen circumstances, it really shouldn't have any major problems moving forward.

What about its rivals?
Either way, it always helps to compare an investment with its most immediate competitors. In the chart below, I've listed the above metrics against those of Safeway's closest competitors. In addition, I've included the highly important five-year dividend growth rate. If Safeway has grown dividends significantly over the past five years, there's a good chance that it will continue to put shareholders first in the future.

Check out how Safeway stacks up below:

Company

Dividend

Yield

Payout

Ratio

Coverage Ratio

5-Year Compounded Dividend Growth Rate

Safeway 2.1% NM 7.95 34.5%
Target (NYSE: TGT) 1.8% 18.6% 7.26 17.5%
Costco Wholesale (Nasdaq: COST) 1.3% 25.9% 5.18 12.4%
Kroger (NYSE: KR) 1.9% 1525% 4.28 N/A

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

The Foolish bottom line
Only you can decide what numbers you're comfortable with. Sometimes, higher yields and greater rewards require additional risk. However, in this situation, there seems to be plenty of cash flow to support Safeway's dividend. (I'd worry more about whether the company can start to turn a profit.)

Whether you're sizing up a dividend, a share repurchase, or an ordinary earnings report, remember to do your own due diligence. Looking at all the relevant numbers in the best context possible may be your best place to start.

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Jordan DiPietro owns no shares. Costco is a Motley Fool Inside Value pick. Costco is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Costco. 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.