Dividend Report Card: Home Depot

In this 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?

The Dividend Report Card wasn't designed as a buy or sell signal but rather as a tool to gauge the health of a company's dividend. For a full explanation of each category, click here for a tutorial.

Today's pupil is Home Depot (NYSE: HD) , which posts a 2.7% yield. When we looked at Home Depot last quarter, it scored a very respectable grade of "B" (3.8 out of 5). Let's see how it did this time around.

Dividend history

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

Home Depot has smartly shifted its dividend policy from one designed for a high-growth company to one that suits a maturing company. In 2006, for example, Home Depot paid out just 15% of its earnings as dividends, whereas today it has a target payout ratio of 40%. This widening payout ratio has largely accounted for the strong dividend per share growth over the past five years.

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

Sustainability

Source: Capital IQ, as of May 13.

If we take Home Depot's operating leases into account, its interest coverage is probably closer to seven times, but that's still quite good and wouldn't have changed the score. Moreover, Morningstar gives Home Depot an impressive "A" credit rating.

Earnings and free cash flow cover have also improved since last quarter.

Growth

Home Depot's most recent dividend increase was 5.8%, from $0.23625 per share to $0.25 per share. With more than $2 in earnings and free cash for each $1 paid in dividends, you may understandably be wondering why the increase wasn't greater.

One reason could be the company's reinvigorated share repurchase program, which sopped up $2.6 billion of shareholder cash versus $1.57 billion in dividends. In fact, if we combine the buybacks and dividend to calculate an "augmented" payout ratio, it's approximately 125% of earnings. This would imply a slightly negative sustainable growth rate.

Competitors
A "ungraded" section of the dividend report card is to see how a stock's current yield stacks up against that of 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.

With its current yield at 2.7%, Home Depot's dividend outlay is well above some of its major competitors and could influence the board to raise future payouts at a more modest rate.

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

Home Depot's score has improved nicely from a "B" in February to an "A" in May, but investors should continue to monitor free cash flow generation and the board's approach to returning shareholder cash. With the current policy seemingly geared to buybacks, dividend investors shouldn't expect double-digit payout growth anytime soon.

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