Dividend Report Card: Diageo

Does the drinks giant's dividend pass the grade?

All dividends are not created equal.

We learned this lesson the hard way in recent years. In 2009 alone, 202 UK companies cut their dividend, whilst another 60 froze their payouts. Because dividends are 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 that 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 Diageo (LSE: DGE).

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

^{Data provided by Capital IQ, as of 20 July, 2010.}

It's good to see that Diageo has grown its dividend at a rate comparable to earnings growth, but that growth has been rather lacklustre in the past five years. A 5% growth rate is better than zero, but ideally, you'd like to see that rate in the higher single digits.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Diageo scores a 3 of 5.

Sustainability

Finding companies with solid financial footing, backed by a strong balance sheet, sufficient profitability, and plenty of free cash flow is at the root of successful dividend investing. There's no point buying a share yielding 5% if you don't believe the dividend is sustainable. For this reason, sustainability gets a 50% weighting in my formula.

To analyse dividend sustainability, I look at three factors:

1. Interest coverage ratio (operating profits / interest costs)

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 cut 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 Diageo, the results are:

^{Data provided by Capital IQ, as of 20 July, 2010.}

Diageo generates more than enough profits and free cash flow to cover its dividend, which is an encouraging sign of sustainability. The interest coverage ratio is a little lower than I'd prefer, but it appears Diageo has no problem paying its creditors.

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. Only this time I'm not just looking to see if there's more than enough profits and cash to sustain the dividend. I want to see how much the payout can grow, so 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 Diageo scored on these metrics:

Diageo certainly has the ability to grow its dividend at a steady clip in the coming years. It currently produces roughly £2 in free cash flow for every £1 it pays out as a dividend, so there is room to pay more. Historically, the company's raised its dividend between 5-7% over rolling five year periods and I see no reason why that can't continue.

Bonus factor

An "ungraded" section of the dividend report card is to 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.

With most of the major brewers/distillers shares paying rather low yields, Diageo's 3.3% yield is relatively high. This lack of "competition" may explain why Diageo, as one of the highest yielding brewers/distillers, has not increased its payout at a faster rate.

Pencils down!

With all the numbers in, here's how Diageo's dividend scored:

Diageo's dividend may not be on high yield investors' radars, but it should be considered for a well-diversified, dividend-focused portfolio due to its strong sustainability and steady growth potential.

More from Todd Wenning:

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• 5 US High Yield Shares Worth Buying Today
• An Insurer To Buy In Thirds

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