Dividend Report Card: Marks & Spencer

Does this share'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 Marks & Spencer (LSE: MKS), which is currently yielding 4.4%.

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 Marks & Spencer has increased its dividend over the past five years, relative to its earnings growth:

^{Data provided by Capital IQ, as of 21 July, 2010.}

Marks & Spencer's 2009 dividend cut obviously set them back in this category, but even with the cut, the dividend per share has increased at a fair rate since 2005.

Past returns don't guarantee future results, however, so dividend history is only 10% of the final grade. That said, for this category, Marks & Spencer scores a 2 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 Marks & Spencer, the results are:

^{Data provided by Capital IQ, as of 21 July, 2010.}

Marks & Spencer's current dividend level appears to be well covered by both earnings and free cash flow and its balance sheet has also improved modestly from where it stood in early 2009. All of these factors suggest that the current dividend is at least sustainable and that another dividend cut does not seem to be on the horizon.

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 Marks & Spencer scored on these metrics:

Coming off a tumultuous two-year period for the company, I wouldn't expect dividend growth to immediately resume at a torrid pace, but there's plenty of potential for Marks & Spencer to resume steady payout growth in the coming years.

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.

All of the major British supermarket shares post healthy yields, so Marks & Spencer's 4.4% yield isn't out of the ordinary. Still, as the highest yielder in the group, the company may have less motivation to increase its payouts at an above-average rate without a concurrent boost to its share price.

Pencils down!

With all the numbers in, here's how Marks & Spencer's dividend scored:

Marks & Spencer's sharp dividend cut in 2009 may have left some income-minded investors with a bad taste in their mouth -- once bitten, twice shy, after all -- but the current dividend looks rather healthy.

More from Todd Wenning:

• Dividend Report Card: Diageo
• A Foolish Fracas: Sainsbury vs. Tesco
• 5 US High Yield Shares Worth Buying Today

> Fool analyst Todd Wenning does not own shares of any company mentioned.

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