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 another 250 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 Eight-Ball, but it will hopefully get you pointed in the right direction.

Today's pupil is Coca-Cola (NYSE: KO).

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 Coca-Cola has increased its dividend over the past five years, relative to its earnings growth:

Metric

5-Year Annualized Growth Rate

Dividend per share

10.1%

Diluted earnings per share

9.3%

Data provided by Capital IQ, as of July 19, 2010.

This is what you want to see -- a company increasing its dividend by at least the rate of earnings growth.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Coca-Cola scores a 5 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's made over the past 12 months. Hey, that's cash that could have been paid out as a dividend! Plus, serial acquirers may reduce 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 Coca-Cola, the results are:

Metric

Trailing 12 Months

Final Grade Weighting

Report Card Score
(out of 5)

Interest coverage

25.0

10%

5

EPS payout ratio

54.5%

10%

4

FCFE payout ratio

68.3%

30%

4

Data provided by Capital IQ, as of July 19, 2010.

These are all encouraging signs that the current dividend level is sustainable, and the free cash flow payout ratio has been coming down in recent years, as well.

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 profit 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 Coca-Cola scored on these metrics:

Metric

Trailing 12 Months

Final Grade Weighting

Report Card Score
(out of 5)

EPS payout ratio

54.50%

10%

3

FCFE payout ratio

68.30%

20%

3

Sustainable growth rate

14.15%

10%

5

Coca-Cola has a fairly typical profile for a blue-chip company, as it pays out a majority of its earnings and free cash as dividends. It has some more room to increase its payout ratios, but the dividend growth will be primarily driven by its ability to increase profit.

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.

Company

Dividend yield

PepsiCo (NYSE: PEP)

3.1%

Dr Pepper Snapple Group (NYSE: DPS)

1.6%

Kraft Foods (NYSE: KFT)

4.0%

Each of these companies has a strong consumer franchise (although arguably not as strong as Coke's) and offers the prospect of increased future dividends. Given these yields, Coca-Cola's current yield of 3.3% doesn't appear to be out of the ordinary.

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

Weighting

Category

Final Grade

10%

History

5

10%

Balance sheet

5

10%

Income statement

4

30%

Free cash flow

4

10%

Income statement

3

20%

Cash flow

3

10%

Sustainable growth

5

100%

Total score (out of 5)

4.0

 

Final grade

B

This is a very solid "B." The company's score was held back by the growth section, but that certainly doesn't mean Coca-Cola's dividend isn't capable of growing at an above-average rate in the coming years.

Fool analyst Todd Wenning does not own shares of any company mentioned. Coca-Cola is a Motley Fool Inside Value selection. Coca-Cola and PepsiCo are Motley Fool Income Investor picks. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Coca-Cola. The Fool has a disclosure policy.