There are a lot of things to consider before buying an interest in a publicly traded company. These considerations include the company's business model, potential for future earnings growth, and corporate governance. Another important consideration for many investors is the dividend. Dividends are great, because not only can they provide investors with a little bit of cushion to the downside, but they are also used by management as a way to communicate its confidence in the company's future.
Today, let's look at the dividends from three of the biggest players in the retail sector: Wal-Mart (WMT), Target (NYSE:TGT) , and Costco (NASDAQ:COST). Let's see how the dividends from these three companies stack up in terms of strength, sustainability, and future potential.
The most obvious consideration when comparing dividends from different companies is the dividend yield, which represents the percentage of your investment that you receive back over the next 12 months, provided that the dividend doesn't change over that time.
Table 1: Dividend Yields of Wal-Mart, Target, and Costco
Target has the strongest dividend at this point in time, when it comes to dividend yield.
It's not all about the dividend yield when it comes to the strength of the company's dividend. If the dividend doesn't grow, then its purchasing power will be reduced over time due to the effects of inflation. If a company does not increase its dividend over time, then that could signal that management isn't as confident in the company's future. For these reasons, income investors like to see companies that not only pay strong dividends, but dividends that are increased on a regular basis.
Table 2 shows impressive double-digit dividend growth rates for all three companies that easily outpace inflation. However, it should be mentioned that Wal-Mart's most recent increase was by only 2.1%, after an 18.2% increase during 2013. Target's most recent increase was by 19.4%, which is steady with the 20% increases in both 2011 and 2012. Costco's most recent dividend increase was 12.7%, which is inline with what the company has done over the last 5 years.
It should be mentioned that Costco's figures do not include the one-time special dividend of $7 per share that was paid out in 2012 due to worries over taxes ahead of the "fiscal cliff" debacle. The dividend growth figures above only deal with regular quarterly dividends.
Wal-Mart has increased its dividend every year for the last 41 years, while Target has increased its dividend every year for the last 46. For this reason, these two companies are on the list of S&P 500 Dividend Aristocrats, an elite group of companies who have increased their dividends for at least 25 consecutive years. Costco has increased its dividend every year for the last 10 years.
In terms of past overall dividend growth, Target wins out here.
Free Cash Flow Payout Ratio
While it's nice to see high yields and strong dividend growth rates, we need to make sure that the company in question is generating enough free cash flow to keep the dividend payments going. For this reason, I like to calculate the free cash flow payout ratio, which is the percentage of free cash flow that is eaten up by dividends over a given period of time. Lower free cash flow payout ratios are better as they leave more room for other activities as well as for future dividend increases.
Free cash flow is basically the cash flow a company generates in its operations minus capital expenditures required to maintain or expand the business.
Table 3 shows that none of the dividends from these three companies appear to be in any sort of danger. These three companies are currently generating more than enough free cash flow to cover their dividend payouts. Wal-Mart's payout ratio ballooned out to 67% from 46% a year ago, due in large part to the company's 18.2% dividend hike in 2013. From now on, its dividend growth will need to more or less match its earnings growth. Costco's 4-year average free cash flow payout ratio is very high due to that huge special dividend mentioned earlier. In the years before that, the payout ratio was about 20%. Both Target and Costco can still use the expansion of their free cash flow payout ratios, along with earnings growth, to increase their dividends.
Earnings Per Share Growth Forecasts
While it's good to look at what past dividend payouts have been and how they relate to past earnings, we need to get an idea as to what future dividend payouts are going to look like. One of the ways in which we do this is by looking at analyst forecasts for earnings-per-share growth.
From Table 4, Target looks like it's going to grow profits at a much faster rate than both Wal-Mart and Costco.
All three of these retail companies have strong dividends that are more than supported by free cash flow. With an elevated free cash flow payout ratio, resulting from its large dividend increase last year, Wal-Mart should continue to increase its dividend at a low to mid single-digit rate if the analyst estimates hold true. Costco is only expected to grow earnings at 3% this year, but with a free cash flow payout ratio of just 38%, it should have no problem continuing to increase its dividend at a double-digit rate. However, its current yield is so small, that it is all but negligible for most investors, especially when compared with yields on cost that you can achieve with Wal-Mart or Target if current dividend growth rates prevail for several more years.
Target, meanwhile, has the highest yield and the highest dividend growth rate. With earnings per share expected to grow at an annual rate of over 20% for the next couple of years, along with a free cash flow payout ratio of just 33%, it is my opinion that Target's dividend has the best prospects of the three.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.