Costco's Dividend Has Years Of Growth Ahead For Investors

Dec. 6.11 | About: Costco Wholesale (COST)

We understand the importance of a safe and growing dividend for the income investor. So in this article, let's evaluate the dividend of Costco (NASDAQ:COST). In the spirit of transparency, our full report on Costco can be found here.

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First of all, Costco's dividend yield is only at 1.1%, so it's not a huge income generator. But we think the safety of its dividend is excellent. We measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate in any given year, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges (read hiccups in operations), which makes earnings an even less-than-predictable measure of the safety of the dividend in any given year. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying these cash outlays well into the future.

As such, we've developed the forward-looking Valuentum Dividend Cushion. The measure is a ratio that sums the existing cash a company has on hand plus its expected future free cash flows over the next five years and divides that sum by future expected dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends. As income investors, however, we'd like to see a score much larger than 1 for a couple reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future.

For Costco, this score is 5.5, offering both an excellent "cushion" and revealing excess capacity for future dividend growth. The beauty of the Dividend Cushion is that it can be compared apples-to-apples across companies.

Now on to growth. As we mentioned above, we think the larger the "cushion" the larger capacity it has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. As such, we evaluate the company's historical dividend track record. If there have been no dividend cuts in 10 years and the company has a nice growth rate, its future potential dividend growth is excellent, which is the case for Costco.

Also, by employing a matrix, one can see above that Costco has a solid dividend - the cross section of its excellent safety and excellent future potential growth scores. And because capital preservation is also an important consideration, we assess the risk associated with the potential for capital loss (offering investors a complete picture). In Costco's case, we think the shares are fairly valued, so the risk of capital loss is medium. If we thought Costco was undervalued, we'd consider the risk to be low. To view a narrated presentation on our valuation process, please click here.

All things considered, we're fans of the growth potential and safety of Costco's dividend, but its yield is a bit low to get us excited.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.