Dividend investing is a tried-and-true strategy for generating strong, steady returns in economies both good and bad. But as corporate America's slew of dividend cuts and suspensions over the past few years has demonstrated, it's not enough simply to buy a high yield. You also need to make sure those payouts are sustainable.
First and foremost, dividend investors like a large forward yield. But if a yield gets too high, it may reflect investors' doubts about the payout's sustainability. If investors had confidence in the stock, they'd be buying it, driving up the share price and shrinking the yield.
Home Depot yields 2.5%, a bit higher than the S&P 500's 2.0%.
2. Payout ratio
The payout ratio might be the most important metric for judging dividend sustainability. It compares the amount of money a company paid out in dividends last year to the earnings it generated. A ratio that's too high -- say, greater than 80% of earnings -- indicates that the company may be stretching to make payouts it can't afford, even when its dividend yield doesn't seem particularly high.
Home Depot has a moderate payout ratio of 43%.
3. Balance sheet
The best dividend payers have the financial fortitude to fund growth and respond to whatever the economy and competitors throw at them. The interest coverage ratio indicates whether a company is having trouble meeting its interest payments -- any ratio less than 5 times is a warning sign. Meanwhile, the debt-to-equity ratio is a good measure of a company's total debt burden.
Let's examine how Home Depot stacks up next to its peers:
|Home Depot||61%||12 times|
Source: S&P Capital IQ.
Home Depot, Lowe's, and Lumber Liquidators appear to be in pretty good shape with their debt burdens. Sears … not so much. Although this has been the first year that its operating income actually dropped its interest payments, Sears' interest coverage has been trending downward (along with its income) for some time, and the struggling retailer hasn't been above the 5-times mark since 2008.
But how have their businesses been faring? That's what we'll look at next.
A large dividend is nice; a large, growing dividend is even better. To support a growing dividend, we also want to see earnings growth.
5-year Earnings per Share Growth
5-Year Dividend Growth
Source: S&P Capital IQ. * Negative earnings. ** 3-Year Growth.
The housing market decline has obviously hurt demand for home-improvement products. While accurate, these growth figures don't quite capture the magnitude of the earnings decline experienced at Lowe's (down 20% in 2008, another 19% in 2009) before it began to recover in 2010. Home Depot's earnings held much steadier throughout the downturn. Meanwhile, Lumber Liquidators, a low-cost supplier of hardwood flooring, actually gained strength during the downturn with its laser-like focus on providing savings on a single product to cash-strapped consumers.
The worst appears to be behind the industry, with Home Depot, Lowe's, and Lumber Liquidators all achieving same store-sales growth, about 1% to 2%, over the past twelve months. (Struggling Sears, on the other hand, once again saw a same-store sales decline.)
The Foolish bottom line
While Lowe's may not have the trailing growth of a dividend dynamo, it nonetheless exhibits a fairly strong dividend bill of health based on its moderate yield, low payout ratio, and manageable debt. If you're looking for some great dividend stocks, I suggest you check out "Secure Your Future With 11 Rock-Solid Dividend Stocks," a special report from the Motley Fool about some serious dividend dynamos. I invite you to grab a free copy to discover everything you need to know about these 11 generous dividend-payers -- simply click here.