Before buying an interest in a publicly traded company, there are a number of things you should think about. These things include the company's business model, valuation and future earnings growth. Another important consideration is the dividend. It's important to remember that from 1930 to 2012, dividends accounted for about 42% of the gains in the S&P 500.
Many investors pursue dividend-paying stocks to augment their returns with a nice income stream. A lot of these investors will buy dividend-paying stocks that are in many different sectors of the economy in order to diversify their risk profiles.
Today, let's take a look at two of the biggest dividend payers in the home improvement industry, Lowe's (LOW) and Home Depot (HD), and assess the strength and sustainability of their dividends, as well as potential for future dividend growth.
The most obvious consideration when comparing dividends from different companies is the dividend yield, which represents the percentage of your investment that you will receive back over the next 12 months, provided that the dividend doesn't change over that time.
Table 1: Dividend Yields from Lowe's and Home Depot
Right now, Lowe's yields just 1.6%. The 2.5% yield from Home Depot is actually a forward yield that is based on its new quarterly dividend of $0.47 per share that was announced back in February. The yield on Home Depot over the last five years has ranged between 1.6% and 4.0%. The 4% yields were seen back in 2009, during the depths of the financial crisis. I doubt we'll see 4% yields from either of these two companies anytime soon. Over the last five years, the dividend yield from Lowe's ranged between 1.3% and 2.5%.
So, at this point in time, Home Depot has the higher dividend yield by far.
When analyzing a dividend, there's more to it than just the yield. As an income investor, you want that dividend to grow over time in order to protect your income stream from the erosive effects of inflation, as well as to show confidence from management in the company's outlook.
Table 2: Dividend Growth Rates of Lowe's
Table 3: Dividend Growth Rates of Home Depot
Tables 2 and 3 both show impressive double-digit dividend growth rates from Lowe's and Home Depot over the last three fiscal years. Lowe's has increased its dividend each year for the last 51 years, while Home Depot has increased its dividend five times in the last five years, after freezing it for three years.
While Home Depot has increased its dividend at a faster rate over the last two years, both companies are looking very good in the dividend growth department.
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 companies in question are 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 4: Free Cash Flow Payout Ratios from Lowe's
Table 5: Free Cash Flow Payout Ratios from Home Depot
Tables 4 and 5 show that the dividends from these two companies do not appear to be in any sort of danger at this time, with dividends consuming well below half of each company's free cash flow. One reason for this is that Home Depot is targeting a payout ratio of 50% of earnings per share, and its current payout is in line with that. Another reason is each company's emphasis on buybacks, with Home Depot spending nearly four times as much money on buybacks as on dividends over the past year. Over the last four years, Lowe's has spent close to five times as much on buybacks as on 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.
The earnings per share forecasts look great for both companies over the next two years, as analysts expect both companies to increase earnings per share at a double-digit clip. Lowe's is expected to grow at a rate above 20%.
At this point in time, the dividends of both Lowe's and Home Depot are safe, with current payouts consuming less than half of each company's free cash flow. These low free cash flow payout ratios leave plenty of room for dividend growth later on. However, given that Home Depot has targeted a payout ratio that is equal to 50% of earnings per share and that its current payout already matches that, we should expect its dividend growth to be in line with its earnings growth going forward. But, with earnings per share growth expected to be in the 16-18% range, we should continue to expect Home Depot to crank out double-digit dividend increases in the near future. With 21% earnings per share growth on the horizon for Lowe's, we should expect the same thing out of them.
What really sets these two companies apart with regard to the dividend is the dividend yield. At 2.5%, the dividend yield of Home Depot is more than 50% greater than that of Lowe's. This means that even if Lowe's chose to accelerate its dividend growth rate to a rate above that of Home Depot, it would probably still take a long time for the yield on cost for an investment in Lowe's to catch up with that of an investment in Home Depot, if Home Depot's dividends grow at a modest rate. Then, it would probably take twice as long for the cumulative dividends from Lowe's to catch up with those that you could get from an investment in Home Depot.
So, as to who has the better dividend, I give the edge to Home Depot. Of course, please keep in mind that this is not a buy or sell call on either stock. The dividend is just one of many considerations that need to be taken into account when doing the proper due diligence on both stocks.
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.