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 Costco Wholesale (Nasdaq: COST), which has a 1.5% yield.

Dividend history

Metric

5-Year Annualized Growth Rate

Dividend per share

12.4%

Diluted earnings per share

6.2%

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

Costco's current yield may be lower than the S&P 500 average, but it only began paying a regular dividend in 2004. Since it paid that first $0.10 per share quarterly dividend six years ago, Costco has been a steady dividend hiker, raising the payout each year without fail.

Even though it doesn't have a decades-long dividend history, Costco's regular dividend increases help it score a 5 of 5 in this category.

Sustainability

 Metric

Trailing 12 Months

Final Grade
Weighting

Report Card Score
(out of 5)

Interest coverage

18.2 times

10%

5

EPS payout ratio

25.3%

10%

5

FCFE payout ratio

19.0%

30%

5

Source: Capital IQ, as of Aug. 18, 2010.

If its operating leases were considered debt, Costco would likely have an additional $1.2 billion-$1.3 billion worth of debt on its books, which would put its "true" interest coverage ratio near 11 -- still a 5 of 5 in my book. There's no question that the current dividend is well covered by both profits and free cash flow, so sustainability of the current payout level doesn't appear to be a problem.

Growth

Metric 

Trailing 12 Months

Final Grade
Weighting

Report Card Score
(out of 5)

EPS payout ratio

25.3%

10%

4

FCFE payout ratio

18.9%

20%

5

Sustainable growth rate

9.1%

10%

4

Costco generates more than enough profits and free cash flow to not only sustain its dividend, but continue to increase it in coming years. If it can maintain an average return on equity between 12% and 14%, a five-year dividend growth rate between 8%-10% is not out of the question.

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

Family Dollar Stores (NYSE: FDO)

1.4%

Target (NYSE: TGT)

1.9%

Wal-Mart (NYSE: WMT)

2.4%

Costco's dividend yield of 1.5% is below its peer group average of 2.2%, so it shouldn't feel artificial pressure to slow down its dividend growth to remain in line with peers. In fact, the opposite may be true.

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

Weighting

Category

Final Grade

10%

History

5

 

Sustainability

 

10%

Interest Coverage

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

5

100%

Total Score (Out of 5)

4.8

 

Final Grade

A

Its low current yield is nothing to write home about, but Costco is one of the best-run companies out there. As our Motley Fool Stock Advisor team recently noted:

All that Costco does to keep its members happy — including keeping employees happy with high pay and perks — often gets criticized as not maximizing profitability, but it drives annual membership retention of 87%. That, in turn, drives stable growth that other retailers just can’t match.

Costco could be a strong growth and income play for the longer term, meaning that its dividend growth rate may exceed the market average in coming years. If you have at least five years in mind for your holding period, Costco is an idea that's worth further research.

If you're ever near Hartsdale, N.Y., Fool analyst Todd Wenning recommends Dairy Del for an excellent cheesesteak. He doesn't own shares of any company mentioned. Costco and Wal-Mart are Motley Fool Inside Value selections. Costco is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Costco and has a disclosure policy.