Dividend Report Card: Wal-Mart

All dividends are not created equal.

We learned this lesson the hard way in recent years. In the first quarter of 2009, a record 367 firms cut their dividend payouts, only to be followed by an additional 233 in the next quarter. Because dividends are paid at the board of directors' discretion, when times get tough, a firm's dividend payout can meet the corporate chopping block.

Avoiding the executioner
Certainly things have gotten better since those dark days, but with many concerns remaining about the global economy, investors would be wise to ask the following three questions of their companies' dividends:

1. Over time, has this company steadily increased its payouts?
2. How sustainable is the dividend?
3. Does the company have room to further increase the dividend?

To help you out, I've created a proprietary dividend report card, which seeks to answer these questions by analyzing a company's financial statements. It's not intended to be a Magic 8-Ball, but it will hopefully get you pointed in the right direction.

Today's pupil is Wal-Mart (NYSE: WMT), which currently posts a 2.4% yield.

Dividend history
Income-minded investors prefer a good track record of rising dividend payouts. Not only is it a sign that management is dedicated to returning shareholder value, but also that the board of directors expects future profitability.

Let's see how well Wal-Mart has increased its dividend over the past five years, relative to its earnings growth:

Source: Capital IQ, as of July 23, 2010.

This is exactly what you want to see -- a company growing its dividend at a rate comparable to earnings growth. Wal-Mart has been a consistent dividend growth story, having increased its dividend for 36 consecutive years.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Wal-Mart scores a 5 out of 5.

Sustainability
Finding companies with solid financial footing, backed by a strong balance sheet, sufficient profitability, and plenty of free cash flow is at the root of successful dividend investing. There's no point buying a stock yielding 5% if you don't believe the dividend is sustainable. For this reason, sustainability gets a 50% weighting in my formula.

To analyze dividend sustainability, I look at three factors:

1. Interest coverage ratio (EBIT / interest expense).
2. Earnings dividend payout ratio (dividend per share / earnings per share).
3. Free cash flow dividend payout ratio (dividends paid / free cash flow to equity).

It's worth noting that in my definition of free cash flow to equity, I also back out any acquisitions the company has made over the past 12 months. Hey, that's cash that could have been paid out as a dividend! Plus, serial acquirers may cut a dividend to help fund a new acquisition, so we want to be sure there's still plenty of cash to go around after all investments have been made.

For Wal-Mart, the results are:

Source: Capital IQ, as of July 23, 2010.

These are all encouraging signs that the current dividend level is sustainable. One caveat to keep in mind when you're looking at a retailer's balance sheet is that, in most cases, the company's leases are considered operating leases and so aren't listed on the balance sheet as debt. However, savvy investors will want to convert those operating leases to debt to get a clearer picture of the company's actual obligations. Still, Wal-Mart's interest coverage ratio scores a "5" even after adjustments are made.

Growth
Once you know that a dividend is sustainable, you'll want to see how much room the company has to raise its payout. It may not be quite as important as dividend sustainability, but it's still an essential factor for income-minded investors who want their payouts to increase at rates well above inflation.

For this reason, growth makes up the last 40% of the final grade.

In this section, I once again use the earnings and free cash flow payout ratios. Only this time I'm not just looking to see if there's more than enough profits and cash to sustain the dividend. I want to see how much the payout can grow, so the lower the payout ratios, the better.

I also consider a firm's implied sustainable growth rate, defined as return on equity times its retention ratio (the percentage of profits it keeps to reinvest in the business). This is the highest achievable growth rate the company can have without changing its capital structure.

Here's how Wal-Mart scored on these metrics:

Wal-Mart generates roughly $3 in profit and free cash flow for every $1 it pays out in dividends, and given its consistent return on equity over 20%, I see no reason why Wal-Mart couldn't continue raising its dividend in the coming years.

Bonus factor
An "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against direct competitors'. If it's too high relative to competitors' yields, the board could be tempted to slow the growth rate, or vice versa, to bring it more in line with the industry average.

Retailers, who spend a substantial amount on store expansion and maintenance each year, typically have lower yields and this group of discounters is no exception. Wal-Mart's 2.2% yield doesn't stand out as too high or too low.

Pencils down!
With all the numbers in, here's how Wal-Mart's dividend scored:

There's no question about it -- Wal-Mart is a fine dividend stock, even if its yield isn't anything to write home about. Despite the fact that Wal-Mart's stock price was relatively anemic over the past decade, its dividend has increased more than five-fold. No one knows what the next year or two will bring to Wal-Mart's stock price, but the dividend appears to remain quite healthy.