Many companies talk about the ways they enhance shareholder value by returning cash via dividends or stock buybacks, but investors shouldn't just take the company's word for it.

In this series, we'll investigate how companies spent free cash flow over the past five years. By doing so, we hope to gain insight into whether the company's management might be good stewards of shareholder capital.

Today, we'll take a look at home improvement retailer, Home Depot (NYSE: HD)

How do they spend free cash?
First, let's have a look at how much free cash flow the company has generated in each of the last five years and how much of that has gone to dividends and buybacks.

Editorial

Source: Capital IQ as of June 29, 2011. Free cash flow = net income + depreciation - capital expenditures - change in noncash working capital.

Over the past few years, Home Depot has maintained a regular dividend policy and conducted lumpy share buybacks.

Home Depot has paid a cash dividend each year since 1987 and has a fairly good track record of increasing payouts each year, though it held its payout steady from 2000-2001 and again from 2006-2009 in response to those recessionary periods. That didn't stop them, however, from spending a boatload on share buybacks in 2007. The funds may have been deployed in an effort to reassure the market that the company believed in the long-term efficacy of the business in the early stages of the housing bust.

A little later on, we'll figure out if those buybacks were well-timed or not.

Is the dividend covered?
Next, let's see how much of the company's free cash flow has gone to dividends.

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

Another reason that Home Depot may have held its dividend steady from 2006-2009 was that its free cash flow cover quickly deteriorated as the housing bubble burst. Things seem to have improved, though, and have returned to a more normal range.

Are they good investors?
Companies are notoriously bad investors in their own stock. Consider that in 2007, when the market was hitting record highs, S&P 500 companies bought back a record $589 billion versus $246 billion in cash dividends; in 2009, when the market was around its nadir, buybacks hit record lows.

Is Home Depot an exception?

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Source: Capital IQ.

In hindsight, Home Depot's massive repurchase program in late 2007 and early 2008 may not have been a terrible use of shareholder cash (though I'm sure some would have preferred a special dividend instead). It doesn't appear that they repurchased shares at the earlier peak, but at more reasonable prices between $26 and $31 per share.

Competitors
How does Home Depot's use of free cash flow stack up against some of its major competitors over the last four quarters?

Company

Free Cash Flow

Share Buybacks

Dividends

Home Depot $3,309 $3,401 $1,573
Lowe's (NYSE: LOW) $2,029 $3,184 $589
Sears Holdings (Nasdaq: SHLD) ($412) $1,097 $0
Lumber Liquidators (NYSE: LL) ($20) $0.402 $0

Source: Capital IQ. All figures in millions as based on trailing-12-month data.

As far as home retailers go, Home Depot clearly has the most robust dividend policy, whereas Lowe's and Sears prefer to use buybacks to return cash to shareholders.

Foolish bottom line
Home Depot appears to be making fair use of its free cash flow, and its well-covered dividend (2.8% yield) may be attractive to income-focused investors.

Investors should keep an eye on its buyback discipline in coming years. If Home Depot begins buying back stock at lofty prices, it may be time to revisit its use of free cash flow.

Todd Wenning is the advisor of Motley Fool (UK) Dividend Edge. You can follow him on Twitter. He does not own shares of any company mentioned. The Motley Fool owns shares of Lumber Liquidators. Motley Fool newsletter services have recommended buying shares of Home Depot and Lowe's.

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