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 2.6% yield.

Dividend history

Metric

5-Year Annualized Growth Rate

Dividend per share

18.8%

Diluted earnings per share

(6.7%)

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

Just about any company with strong connections to the U.S. housing industry in 2005-2006 will have posted lackluster five-year earnings figures -- Lowe's (NYSE: LOW), Williams-Sonoma (NYSE: WSM), and Sears Holdings (Nasdaq: SHLD), for instance, also have negative five-year earnings growth. Fortunately, Home Depot did have enough room to raise its dividend at a very good clip during this period.

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

 Metric

Trailing 12 Months

Final Grade
Weighting

Report Card Score
(out of 5)

Interest coverage

8.8 times

10%

5

EPS payout ratio

50.6%

10%

4

FCFE payout ratio

53.7%

30%

4

Source: Capital IQ, as of Feb. 2.

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. It appears to have plenty of earnings and free cash flow cover to maintain the current dividend.

Growth

Metric 

Trailing 12 Months

Final Grade
Weighting

Report Card Score
(out of 5)

EPS payout ratio

50.6%

10%

3

FCFE payout ratio

53.7%

20%

3

Sustainable growth rate

7.8%

10%

3

Potential dividend growth is the biggest question for Home Depot. Since the housing boom went bust, the company has dramatically slowed reinvestment in the business, reducing capital expenditures as a percentage of sales from 5% in 2005 to just 1.6% in the past 12 months, and store count has been relatively flat since 2008.

This has been great for the dividend, as it's freed up extra cash flow to cover the payout, but eventually companies need to reinvest to fuel future growth. Home Depot has been focusing on improving the efficiencies in its existing stores, but it's unclear at this point how much sustainable growth it can yield from those investments.

At this point, assuming mid-single-digit dividend growth over the next few years is probably a fair estimate.

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.

Company

Dividend Yield

Median Analyst Est. Long-Term EPS Growth

Lowe's

1.8%

14.5%

Tractor Supply (Nasdaq: TSCO)

0.5%

15.4%

Sears Holdings

N/A

10.0%

With its current yield at 2.6%, 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:

Weighting

Category

Final Grade

10%

History

5

 

Sustainability

 

10%

Interest Coverage

5

10%

EPS Payout Ratio

4

30%

FCFE Payout Ratio

4

 

Growth

 

10%

EPS Payout Ratio

3

20%

FCFE Payout Ratio

3

10%

Sustainable growth

3

100%

Total Score (out of 5)

3.8

 

Final Grade

B

Home Depot's final score has declined slightly from "B+" (4.2 out of 5) since we last looked at it in July. This has been primarily because of an increase in non-cash working capital and isn't grounds for major concern. Overall, Home Depot's dividend looks healthy, but investors should pay attention to the company's growth strategy.

Want some more dividend ideas? Click here for a free report from Motley Fool expert analysts: "13 High-Yielding Stocks to Buy Today."

Todd Wenning is advisor of Motley Fool UK Dividend Edge. He does not own any shares in companies mentioned here. Home Depot and Lowe's Companies are Motley Fool Inside Value choices. Motley Fool Options has recommended a covered call strategy on Lowe's. The Fool has a disclosure policy.