Many companies talk about the ways they enhance shareholder value by returning cash through 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 health-care giant Johnson & Johnson (NYSE: JNJ)

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

Source: Capital IQ as of July 12, 2011. Free cash flow = net income depreciation - capital expenditures - change in noncash working capital.

Johnson & Johnson has one of the most prestigious dividend track records in the S&P 500, having raised payouts for 49 consecutive years. Still, it's bought back nearly as much of its stock ($23.5 billion) since 2006 as it's paid out in dividends ($24.9 billion).

Over the past two years, however, it appears that buybacks have taken a back seat and that Johnson & Johnson has primarily returned shareholder cash through dividends. A little later on, we'll see whether those stock buybacks turned out to be good investments.

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

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

Johnson & Johnson has been incredibly consistent over this five-year period, paying out between 41% and 44% of free cash flow each year as dividends. As such, Johnson & Johnson's dividend (3.4% yield) seems well covered by free cash flow.

Is it a good investor?
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 Johnson & Johnson an exception?

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

Just like its free cash flow payout ratio, Johnson & Johnson's share price has been fairly consistent since 2006, hovering roughly between $50 and $70 per share.

At this point, it's hard to say whether the company's increased buyback activity from 2006 to 2008 was, in hindsight, a good investment. We may need another few years before we can draw a conclusion.

In lieu of buybacks, it seems Johnson & Johnson has retained the majority of its remaining free cash flow after paying dividends -- cash and short-term investments have risen from $19.4 billion in 2009 to $26.9 billion today. 

How does Johnson & Johnson's use of free cash flow stack up against some of its major competitors over the past four quarters?


Free Cash Flow

Share Buybacks


Johnson & Johnson $12,299 $2,849 $5,934
Abbott Laboratories (NYSE: ABT) $7,080 $77 $2,735
Merck (NYSE: MRK) $7,933 $1,593 $4,720
Baxter (NYSE: BAX) $1,827 $1,655 $694

Source: Capital IQ, a division of Standard & Poor's. All figures in millions as based on trailing-12-month data.

Foolish bottom line
Johnson & Johnson appears to be making fair use of its free cash flow, and its well-covered dividend may be attractive to income-focused investors.

Investors should keep an eye on its use of free cash flow in coming years. Johnson & Johnson is currently returning about 70% of its free cash between buybacks and dividends. Frankly, it could afford to return a higher percentage to shareholders and lean on its sterling AAA-rating if it needs to raise cash.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.