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, but 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 warning signs that may alert you, and these red flags could be the crucial factor in determining whether a company is likely to continue paying its dividend. Today, let's drill beneath the surface and check out McGraw-Hill (NYSE: MHP).

What's on the surface?
McGraw-Hill, which operates in the publishing industry, currently pays a dividend of 2.59%. That's certainly nothing to sneeze at, as 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 the company's ability to keep that cash rolling. The first thing to look at is its reported dividends versus reported earnings. If you happen to see dividend payments that are growing more rapidly than earnings per share, that may be an initial signal that something just isn't right. Check out the following graph for details of the past five years.


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

Clearly, there doesn't seem to be a problem here. McGraw-Hill has been able to boost its earnings at an adequate pace and keep its dividends in check at the same time.

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, McGraw-Hill's payout ratio is 34.48%. It's obvious that, at least on the surface, McGraw-Hill doesn't have any problem generating enough income to support that nice dividend.

More important than checking out the payout ratio may be simply taking a peek at McGraw-Hill's cash flow. Companies use free cash flow -- all the cash left over after subtracting out 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. McGraw-Hill's coverage ratio is 4.89, which is more than enough cash on hand to keep pumping out that 2.59% 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 McGraw-Hill's closest competitors. In addition, I've included the five-year dividend growth rate, which is also a very important indicator. If McGraw-Hill 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 McGraw-Hill stacks up.






Coverage Ratio

5-Year Compounded Dividend Growth Rate






Pearson (NYSE: PSO)





Gannett (NYSE: GCI)





Washington Post (NYSE: WPO)





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

The Foolish bottom line
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, McGraw-Hill'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. However, with its 4.8 coverage ratio, I wouldn't necessarily be too worried. 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.

Jordan DiPietro owns no shares of the companies mentioned here. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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.