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 Microsoft (Nasdaq: MSFT).

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 Microsoft has increased its dividend over the past five years, relative to its earnings growth:

Metric

5-Year Annualized Growth Rate

Dividend per share

16.7%

Diluted earnings per share

13.4%

Data provided by Capital IQ, as of July 20, 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, Microsoft 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 the root of successful dividend investing. There's no point buying a stock yielding 5% if you don't believe its 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 Microsoft, the results are:

Metric

Trailing 12 Months

Final Grade Weighting

Report Card Score
(out of 5)

Interest coverage

NM

10%

5

EPS payout ratio

26.6%

10%

5

FCFE payout ratio

24.9%

30%

5

Data provided by Capital IQ, as of July 19, 2010. NM = Not meaningful.

These are all encouraging signs that the current dividend level is sustainable. The free cash flow payout ratio has also been coming down in recent years. It's clear that Microsoft has the financial resources to sustain its dividend payout.

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. But this time, I'm not just looking to see whether there's more than enough profit and cash to sustain the dividend; I want to see how much the payout can grow. Thus, 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 Microsoft scored on these metrics:

Metric

Trailing 12 Months

Final Grade Weighting

Report Card Score
(out of 5)

EPS payout ratio

26.6%

10%

4

FCFE payout ratio

24.9%

20%

4

Sustainable growth rate

30.7%

10%

5

Thanks largely to its ubiquitous Windows and Office franchises, Microsoft's been able to generate tremendous profit margins (29% last year) and returns on equity (41%) -- hence the high sustainable growth rate. However, investors are concerned about how well Microsoft will be able to transition from these legacy platforms to its Azure cloud computing platform. The potential for growth is certainly still there, but only if Microsoft makes a good transition to the cloud.

Bonus factor
In an "ungraded" section of the dividend report card, we 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

SAP AG (NYSE: SAP)

0.9%

Oracle (Nasdaq: ORCL)

0.9%

CA Technologies (NYSE: CA)

0.8%

Dividends, once rare in the technology sector, have become more important in recent years -- Oracle, for instance, just started paying a dividend in 2009, and Microsoft started in 2003. Each of these firms generates plenty of cash to cover its payouts, but they retain most of it to reinvest in the business. Microsoft may very well feel that its dividend, in comparison to these peers, is high enough already. Perhaps that's why it didn't boost its payout last year. The company certainly had enough cash to do so.

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

Weighting

Category

Final Grade

10%

History

5

 

Sustainability

 

10%

Interest coverage ratio

5

10%

EPS payout ratio

5

30%

FCFE payout ratio

5

 

Growth

 

10%

EPS payout ratio

4

20%

FCFE payout ratio

5

10%

Sustainable growth rate

5

100%

Total score (out of 5)

4.9

 

Final grade

A+

Microsoft's dividend seems to be sustainable, yet it has plenty of room for growth. The real question is: When will the company raise it again? Mr. Softy didn't increase its payout last year, but with all the cash it has on its balance sheet, it could very well post a substantial increase if the share price rises a bit. My guess is that Microsoft prefers to remain a "growth" company in investors' eyes. A yield greater than 3% could compromise that status.

Fool analyst Todd Wenning does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value selection, and Motley Fool Options has recommended a diagonal call position on the stock. The Fool owns shares of Oracle and has a disclosure policy.