Dividend Report Card: Diageo

In the dividend report card series, we analyze financial metrics to begin answering the following questions about a company's dividend:

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?

For a full explanation of each category, click here for a tutorial.

Today's pupil is Diageo (NYSE: DEO  ) , which has a 3.2% yield.

Dividend history

Metric	5-Year Annualized Growth Rate
Dividend per share	5.2%
Diluted earnings per share	9.1%

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

Diageo has an enviable track record of raising dividends, having boosted payouts each year for well over a decade. The rolling five-year growth rate, however, has declined from 7.1% in 2005 to 5.2% today.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Diageo scores a 3 of 5.

Sustainability

Metric	Trailing 12 Months	Final Grade Weighting	Report Card Score (out of 5)
Interest coverage	3.2 times	10%	3
EPS payout ratio	56.1%	10%	4
FCFE payout ratio	74.6%	30%	4

Source: Capital IQ.

Diageo continues to generate more than enough profits and free cash flow to cover its dividend, which is an encouraging sign of sustainability. The interest coverage ratio is still a little lower than I'd prefer, but Diageo has an "A-" credit rating from Standard & Poor's and appears to have no problem paying its creditors.

Growth

Metric	Trailing 12 Months	Final Grade Weighting	Report Card Score (out of 5)
EPS payout ratio	56.1%	10%	3
FCFE payout ratio	74.6%	20%	3
Sustainable growth rate	20.2%	10%	5

In August, management said it was "recommending a 6% increase in the final dividend" and that they "anticipate at least maintaining this rate of dividend growth in fiscal [year] 2011."

Diageo certainly has the ability to grow its dividend at a steady clip in the coming years, but investors shouldn't get their hopes up for high single-digit annualized growth.

Competitors
An "ungraded" section of the dividend report card involves 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.

Company	Dividend Yield
Fortune Brands (NYSE: FO  )	1.2%
Constellation Brands (NYSE: STZ  )	N/A
Brown-Forman (NYSE: BF-B  )	1.9%

Diageo's dividend yield of 3.2% is above its peer group average, but that may change a bit when Fortune Brands spins-off its premium spirits business, as that segment has generated good free cash flow in the past. My guess is the separate entity would pay a higher dividend than the current group. That may bring Diageo's yield more in line with its peers.

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

Weighting	Category	Final Grade
10%	History	3
	Sustainability
10%	Interest Coverage	3
10%	EPS Payout Ratio	4
30%	FCFE Payout Ratio	4
	Growth
10%	EPS Payout Ratio	3
20%	FCFE Payout Ratio	3
10%	Sustainable growth	5
100%	Total Score (Out of 5)	3.6
	Final Grade	B-

Diageo's free cash flow cover has declined slightly over the past six months because of increased capital investments. Free cash flow can be volatile from period to period, so it isn't a major cause for concern. Still, it's worth keeping an eye on going forward to make sure a trend isn't developing.

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