Linked here is a detailed quantitative analysis of Microsoft Corporation (MSFT). Below are some highlights from the above linked analysis:

Company Description: Microsoft is the world’s largest software company, develops PC software, including the Windows operating system and the Office application suite.

Fair Value: In calculating fair value, I consider the NPV MMA Differential Fair Value along with these four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
2. 20-Year DCF Price
3. Avg. P/E Price
4. Graham Number

MSFT is trading at a discount to 1.), 2.) and 3.) above. The stock is trading at a 6.6% discount to its calculated fair value of $27.44. MSFT earned a Star in this section since it is trading at a fair value.

Dividend Analytical Data: In this section there are three possible Stars and three key metrics, see page 2 of the linked PDF for a detailed description:

1. Free Cash Flow Payout
2. Debt To Total Capital
3. Key Metrics
4. Dividend Growth Rate
5. Years of Div. Growth
6. Rolling 4-yr Div. > 15%

MSFT earned two Stars in this section for 1.) and 2.) above. A Star was earned since the Free Cash Flow payout ratio was less than 60% and there were no negative Free Cash Flows over the last 10 years. The stock earned a Star as a result of its most recent Debt to Total Capital being less than 45%. The company has paid a cash dividend to shareholders every year since 2003 and has increased its dividend payments for 8 consecutive years.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
2. Years to > MMA

The NPV MMA Diff. of the $1,707 is below the $2,700 target I look for in a stock that has increased dividends as long as MSFT has. If MSFT grows its dividend at 12.0% per year, it will take 5 years to equal a MMA yielding an estimated 20-year average rate of 3.9%.

Memberships and Peers: MSFT is a member of the S&P 500. The company’s peer group includes: Apple Inc. (AAPL) with a 0.0% yield, Hewlett-Packard Company (HPQ) with a 0.8% yield and Google Inc. (GOOG) with a 0.0% yield.

Conclusion: MSFT earned one Star in the Fair Value section, earned two Stars in the Dividend Analytical Data section and did not earn any Stars in the Dividend Income vs. MMA section for a total of three Stars. This quantitatively ranks MSFT as a 3 Star-Hold.

Using my D4L-PreScreen.xls model, I determined the share price would need to decrease to $21.60 before MSFT’s NPV MMA Differential increased to the $2,700 minimum that I look for in a stock with 8 years of consecutive dividend increases. At that price the stock would yield 2.96%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the target $2,700 NPV MMA Differential, the calculated rate is 13.6%. This dividend growth rate is slightly above the 12.0% used in this analysis, thus providing no margin of safety. MSFT has a risk rating of 1.50 which classifies it as a Low risk stock.

MSFT was one of the first large tech. companies to pay a dividend in 1990. Since then several other large tech. companies have followed suit, including Intel (INTC) in 1992, Oracle (ORCL) in 2009 and just this month Cisco (CSCO) announced its first dividend. MSFT has seen a slow recovery in IT spending, and suffered market share losses in smartphones and other mobile devices. The company’s free cash flow payout and debt to total capital is low, the combination of its yield, dividend growth rate and years of dividend growth fall short of my expectations. In addition, it failed to raise its dividend for 8 consecutive quarters between November 2008 and August 2010. For these reasons I will remain on the sidelines even though the stock is trading below by calculated fair value of $27.44. For additional information, including the stock’s dividend history, please refer to its data page.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I held no position in MSFT (0.0% of my Income Portfolio), but was long in INTC. See a list of all my income holdings here.

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The down side to this is that great values are harder to find. However, that is not to say they aren’t still out there. Of the 198 stocks I track, only 29 (15%) are trading below my calculated fair value, up from 7% this time last year. Here are some of the more interesting ones…

Becton, Dickinson and Co. (BDX) provides a wide range of medical devices and diagnostic products used in hospitals, doctors’ offices, research labs and other settings.
Fair Value: $109.88 | Recent Price: $84.73 | Yield: 1.6%

Owens & Minor, Inc. (OMI) is a leading domestic distributor of medical and surgical supplies to the acute care market, a health care supply chain management company, and a direct-to-consumer (DTC) supplier of testing and monitoring supplies for diabetes.
Fair Value: $35.94 | Recent Price: $29.56 | Yield: 2.4%

Wal-Mart Stores, Inc. (WMT) is the largest retailer in North America. The company operates retail stores in various formats worldwide. It operates through three segments: Wal-Mart Stores, Sam’s Club, and International.
Fair Value: $63.69 | Recent Price: $54.56 | Yield: 2.2%

Abbott Laboratories (ABT) is a diversified life science company and is a leading maker of drugs, nutritional products, diabetes monitoring devices, and diagnostics.
Fair Value: $55.43 | Recent Price: $47.82 | Yield: 3.6%

Colgate-Palmolive (CL) is a major consumer products company that markets oral, personal and household care, and pet nutrition products in more than 200 countries and territories.
Fair Value: $91.57 | Recent Price: $79.79 | Yield: 2.5%

Johnson & Johnson (JNJ) is a leader in the pharmaceutical, medical device and consumer products industries.
Fair Value: $70.24 | Recent Price: $62.82 | Yield: 3.4%

Walgreen Company (WAG) is the largest U.S. retail drug chain in terms of revenues, this company operates more than 8,000 drug stores throughout the U.S. and Puerto Rico.
Fair Value: $43.77 | Recent Price: $39.32 | Yield: 1.50%

Medtronic Inc. (MDT) is a global medical device manufacturer with leadership positions in the pacemaker, defibrillator, orthopedic, diabetes management, and other medical markets.
Fair Value: $41.34 | Recent Price: $37.41 | Yield: 2.4%

Harleysville Group Inc. (HGIC) underwrites a broad array of personal and commercial coverages. These insurance coverages are marketed primarily in the Eastern and Midwestern United States.
Fair Value: $41.10 | Recent Price: $37.39 | Yield: 3.6%

Microsoft Corporation (MSFT) is the world’s largest software company, develops PC software, including the Windows operating system and the Office application suite.
Fair Value: $28.55 | Recent Price: $27.98 | Yield: 2.3%

I calculate Fair Value weighing The Mid-2 Price and the NPV MMA Price. The wieght depends on where we are in the cycle. Currently it is weighted as 25% Mid-2 price + 75% NPV MMA price. The Mid-2 Price considers four fair value calculations, Avg. High Yield Price, 20-Year DCF Price, Avg. P/E Price and Graham Number, the highest and lowest fair values are excluded and the remaining two calculations are averaged to calculate the Mid-2 price. The NPV MMA Price is where the NPV MMA value equals the NPV MMA target.

Needless to say, we need to consider a lot more than just valuation when making a stock purchase. As dividend growth investors, I would argue that dividend fundamentals are more important than valuation. As long-term buy and hold investors, we can over-come paying too much for a great stock with time. However, time is unlikely to help a fairly valued stock with poor dividend fundamentals.

Full Disclosure: Long OMI, WMT, ABT, CL, JNJ, MDT, HGIC. See a list of all my income holdings here.

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(Photo Credit)

Jon Birger at Fortune notes that there’s still a real buying opportunity in growth stocks, with this years selections slanted toward commodities. Here are the 10 picks for 2010:

Mosaic (MOS) potash production capacity has grown 10% since 2006 and is expected to increase another 60% between now and 2020. And as it rises, the company’s stock seems likely to follow. Currently yielding: 0.3%

Agrium (AGU) earnings are on pace to jump 60% in 2010, and analysts are expecting another 44% bump next year. Currently yielding: 0.1%

Analysts expect Dow‘s (DOW) 2011 earnings to be up 32% — on the heels of a 212% earnings improvement this year. (2009 was a disaster.) Best of all, Dow’s stock isn’t priced to reflect the growth company it has become. Currently yielding: 1.8%

Transocean (RIG) is well indemnified against blowout-related liability. Oil prices have risen 17% since May as global demand has rebounded to 2007 levels and production isn’t keeping up with demand. Currently yielding: 0.0%

Royal Dutch Shell (RDS-B) is a safe place to get a dividend yield. But it has a really good set of strategic initiatives going for it too. Currently yielding: 5.1%

Lennar (LEN) has a history of making lemonade from real estate lemons. During the S&L crisis in the early 1990s, it made a small fortune buying distressed properties at 30¢ or 40¢ on the dollar and then reselling them for 50¢ or 60¢. Currently yielding: 0.9%

East West Bancorp (EWBC) is now believed to be the largest Chinese-American-focused bank in the country. Americans boast a savings rate 19% higher than the national average. Currently yielding: 0.2%

Royal Caribbean (RCL) is trading at a modest 13 times 2011 earnings, but deserves a P/E closer to 17, which was Royal Caribbean’s average valuation from 1997 to 2007. Currently yielding: 0.0%

Entropic (ENTR) is priced more like a value stock: At $9 a share, it trades at 11.7 times projected 2011 earnings. Currently yielding: 0.0%

Apple (AAPL) is definitely not overpriced. Especially not for a company so well positioned in such fast-growing markets. Currently yielding: 0.0%

In selecting their best stocks for 2011, CBS Money Watch focused on value stocks and asked Tom Forester, manager of the Forester Value Fund, to come up with the “top five value stocks for 2011.” His list of companies are mostly household names whose neglect or avoidance by investors leaves them trading at bargain valuations. The list includes:

Microsoft (MSFT) has grown cheap over the years in line with the ebbing of the software maker’s reputation as an innovator. Currently yielding: 2.3%

Hewlett-Packard (HPQ) reputation has been tarnished by the antics of some of the bosses making their way through the executive suite’s revolving door. The result is a PE ratio of about 7.5 times next year’s earnings as investors continue to shun the stock. Currently yielding: 0.8%

Chevron (CVX) is the cheapest of the oil super-majors and is more sensitive than its rivals to the price of oil because more of its business is related to production rather than activities like refining. Currently yielding: 3.3%

CVS Caremark (CVS) trading at roughly 11 times next year’s earnings, investors seem to be ignoring CVS’s valuable pharmacy benefit management business. Currently yielding: 1.0%

Best Buy (BBY) should benefit from strong holiday sales of gadgetry like iPads, Kinect Xboxes, phones and big-screen TVs; and should continue to get a boost from the demise of Circuit City. Currently yielding: 1.7%

Greg Sushinsky in an article on Investopedia selected a sampler of some potent large-cap stocks which pay attractive dividends. Here are his selections and reasons for choosing them:

Verizon Communications (VZ) is expected to offer iPhones next year. Estimates are that it may land as many as 10 million activations when Verizon Wireless begins selling the iPhone. This will be a healthy addition to Verizon’s revenue stream. Currently yielding: 5.6%

Merck (MRK). underlying business has healthy margins and cash flow generation. Even if you scale back the revenue and earnings projections the stock looks cheap. Currently yielding: 4.2%

Conoco Phillips (COP) and other integrated oil company stocks tailed off after the BP (BP) oil spill in the Gulf of Mexico. Currently it sells for less than nine times earnings. Currently yielding: 3.4%

Unilever Plc (UL) has a wide mix of businesses, and the stock got a recent enthusiastic analyst upgrade. The stock is a bit pricey now, but it is projected to continue its earnings rebound. Currently yielding: 3.8%

Coca Cola (KO) continues to grow its earnings despite economic headwinds. The underlying growth and value of the company makes its dividend as solid and stable as any. Currently yielding: 2.8%

As a long-term, buy-and-hold income investor, many of the stocks in the above lists don’t meet my criteria for a buy. Dividend investors are looking for stocks that will perform well over the long run, not just 2011. As such, I prefer to start with this list of stocks.

Full Disclosure: Long CVX, KO. See a list of all my income holdings here.

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(Photo Daniela Baack)

Below are several companies giving their shareholders a raise with increased cash dividends:

Invesco Mortgage Capital (IVR) focuses on investing in, financing and managing residential and commercial mortgage-backed securities and mortgage loans. September 20th the company increased its quarterly dividend 35% to $1.00/share. The dividend is payable on October 27, 2010 to shareholders of record on September 30, 2010. The ex-dividend date is September 28, 2010. The yield based on the new payout is 17.59%.

Arlington Asset Investment (AI) invests in mortgage-related assets. September 21st the company raised its quarterly dividend 71.4% to $0.60/share. The dividend is payable on October 29, 2010 to shareholders of record on September 30, 2010. The ex-dividend date is September 28, 2010. The yield based on the new payout is 10.08%.

ConAgra Foods (CAG) is one of the largest U.S. packaged food processors. September 21st the company increased its quarterly dividend 15% to $0.23/share. The yield based on the new payout is 4.27%.

Microsoft (MSFT) is the world’s largest software company. It develops PC software, including the Windows operating system and the Office application suite. September 21st the company raised its quarterly dividend 23% to $0.16/share. The yield based on the new payout is 2.60%.

The First of Long Island Corp. (FLIC) provides financial services through its wholly-owned subsidiary, The First National Bank of Long Island. September 22nd the company increased its quarterly dividend 10% to $0.22/share. The dividend is payable on October 15, 2010 to shareholders of record on October 5, 2010. The ex-dividend date is October 1, 2010. The yield based on the new payout is 3.55%.

McDonald’s (MCD) is the largest fast-food restaurant company in the world, with about 32,500 restaurants in 117 countries. September 23rd the company raised its quarterly dividend 11% to $0.61/share. The dividend is payable on December 15, 2010 to shareholders of record at the close of business on December 1, 2010. The ex-dividend date is November 29, 2010. MCD is a Dividend Aristocrat and has raised its dividend for 34 consecutive years. The yield based on the new payout is 3.25%.

Covidien (COV) develops, manufactures and distributes medical devices and supplies, diagnostic imaging agents, pharmaceuticals and other health care products used in both clinical and home settings. September 23rd the company increased it quarterly dividend by 11% to $0.20/share.The dividend is payable on Nov. 8 to shareholders of record on Oct. 4. The ex-dividend date is Sept. 30. The yield based on the new payout is 2.04%.

Lockheed Martin (LMT) is the world’s largest military weapons manufacturer and is also a significant supplier to NASA and other non-defense government agencies. September 23rd the company raised its quarterly dividend 19% to $0.75/share. The dividend is payable on Dec. 31 to shareholders of record on Dec. 1. The ex-dividend date is Nov. 29. The yield based on the new payout is 4.17%.

Sanderson Farms (SAFM) in an integrated poultry processing company that produces, processes, markets and distributes fresh and frozen, processed, and prepared chicken products in the United States. September 23rd the company increased its quarterly dividend 13.3% to $0.17/share. The dividend is payable October 19, 2010, to stockholders of record on October 5, 2010. The ex-dividend date is October 1, 2010. The yield based on the new payout is 1.64%.

Selecting stocks with increasing dividends is critical for an income growth strategy. The above list contains stocks that recently raised their dividends; it is not a list of recommend buys. As always, due diligence should be performed before buying or selling any stock. For a list of stocks with a long string of consecutive cash dividend increases, see this list.

Full Disclosure: Long MCD. See a list of all my income holdings here.

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(Photo Credit)

Industry

Have you ever noticed that stocks within an industry often have similar yields? This makes sense when you consider they often have like operations with similar processes, cost structures and margins. This is evident when you look at retailers who buy similar products, resell them in a physical location and have fairly low margins due to the intense competition. Note the yield similarity of Target Corp. (TGT) with a 1.3% yield and Costco (COST) with a 1.5% yield. Even WalMart (WMT) with their economies of scale and focus on efficiency has a yield only slightly higher at 2.4%. The same analysis could be done with The Coca-Cola Company (KO) with a 3.4% yield and Pepsico, Inc. (PEP) with a 3.1% yield.

Maturity and Growth Potential

When Microsoft (MSFT) and Intel (INTC) were formed they paid no dividend. Instead they funneled all their cash back into growing the business. As they matured and growth slowed, each began to pay a very nominal dividend. Today, as they have continued to mature, their yields have continued to increase with MSFT paying 2.0% and INTC paying 3.0%.

Legal Considerations

Real Estate Investment Trusts (REIT), such as Realty Income Corp. (O) and HCP, Inc. (HCP), are not taxed as standalone entities. Instead, they are legally required each year to pay out a certain percentage of their profits as dividends. In effect this forces the shareholders to incur the tax as earnings are generated, leaving the company very little to fund growth. To pay for growth, REIT’s usually have to issue debt and/or equity. All of this combined usually results in REITs having a higher than average yield, for example O yields 5.8% and HCP yields 6.2%.

Risk

Risk still plays an important role in setting the yield for a company. Consider these energy companies with a similar yields: Chevron Corp. (CVX) with a 4.0% yield, Exxon Mobil Corp. (XOM) with a 3.0% yield and ConocoPhillips (COP) with a 4.1% yield. Then there is BP plc (BP) with a 9.0% yield. Is there any question which of these is the more risky stock to own?

The above list is not meant to be an exhaustive, but highlights some of the more common drivers of yield. When we see a yield that appears to be too good to true, we need to ask ourselves why is the yield so high, and is it sustainable?

Full Disclosure: Long CVX, JNJ, ABT, MCD, PG, KO. See a list of all my income holdings here.

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(Photo Credit)

Something Bad Will Happen

Eventually, every investor will hold a stock that falls out of favor and endures a double-digit decline. Understanding this from the onset makes it easier to deal with. If we go ahead and accept this as fact, then when it happens it really shouldn’t be a shock. This sounds simple, but is really an important step in removing emotion from the equation. It is much easier to reach the correct hold or sell decision when evaluating the facts from a rational perspective.

Diversify Your Holdings

When bad things happen to an individual stock, it usually pulls down other stocks in the same industry. Consider the April 20, 2010 explosion and fire on Transocean Ltd’s (RIG) drilling rig Deepwater Horizon licensed to BP where 11 workers were killed. It is more than a month later and BP still has not stopped the oil flow. Below you can see that several companies in the same industry, have all under-performed the S&P 500 (SPY), some more than others:

Limit Your Exposure

The single most important thing you can do to manage the risk associated with holding individual stocks is to simply limit your exposure. My standing rule is to limit each individual stock to no more than 5% of my income portfolio, based on market value and income. If any single company were to go bankrupt and the stock went to $0, my loss would be less than 5% – the market has moved my portfolio more than that in a single day.

At the end of March I held a position in BP that represented 1.6% of my income portfolio and generated 2.1% the portfolio’s income. This small position kept me from being overly concerned. If BP ended up bankrupting, these would not have been dramatic losses. Limiting your exposure in any single stock to a reasonable level lets you sleep at night even when that stock is facing adversity.

Focus On Quality

Your core portfolio should focus on quality with the “meat and potatoes” blue-chip stocks. You might want to add some high-yield and high-risk stocks in limited amounts to “spice” things up. Below are several quality blue-chip stocks that are the cornerstone of most dividend growth investor’s portfolio, along with their risk number:

Finally, it is a good idea to have a written mission statement for your income portfolio that includes your goals and what you will and will not do in the portfolio. It may sound silly to take the time to write this down, but it is very helpful when fear or greed tempts you from your predefined path.

Full Disclosure: Long JNJ, ABT, MCD, PG, KO. See a list of all my income holdings here.

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(Photo: sean carpenter)

Dividend payout is expressed as a percentage and is calculated by dividing annual dividend per share by annual earnings per share (EPS). This tells the investor what percentage of earning the company is paying out as a dividend. At first blush this may seem to make a lot of sense, but it suffers from the following potential problems:

I. Earnings Does Not Equal Cash

As an accountant, I can tell you our profession in its pursuit of theoretical perfection has adulterated the financial statements to the point that it has become very difficult for non-accountants to understand what’s behind the numbers.  Accounting pronouncements such as SFAS No. 143 “Accounting for Asset Retirement Obligations” (ARO) that requires a company to recognize expenses today for cash payments that may not occur for decades or even centuries widens the gap between earnings and cash. Applying “fair value” principles allowed under GAAP, financial institutions (and others) can mark to market debt on their books and create non-cash income or expense, depending on the direction of interest rates. Many point to mark to market accounting as one of the major contributors to the 2008 financial melt-down.

II. Quality of Earnings

Would you rather a company that you are invested in to increase its earnings by 1.) increasing sales and holding cost down or 2.) sell a fully depreciated plant. Obviously, you would rather have the former since it has the possibility of being duplicated over and over again. You can only sell a specific asset once. In addition to cash and non-cash earnings, a statement of earnings also contains operating and non-operating earnings.

A Better Dividend Payout Calculation

A dividend payout ratio is supposed to provide the investor with an indication of how much cash as a percent of earnings the company is paying its investors. As you can see from the above discussion, a payout ratio based on GAAP net earnings could potentially have a lot of noise in it and not provide a clear picture of the economic condition of the business.

What the investor is really wanting to know is what percentage of cash is the company paying as a percentage of cash generated from running the business. The irony here is that operating cash is readily available on the Statement Of Cash Flows in the Operating section. This section focuses on the cash generated by running the business. It excludes cash generated by selling pieces of the business – these are shown in the investing section. It also excludes cash generated from selling stock or issuing debt – these are shown in the financing section.

In calculating a payout ratio, I prefer Free Cash Flow over Operating Cash Flow. Free Cash Flow is Operating Cash Flow less normal capital expenditures (normally the first line in the investing section). For a business to remain viable, it must replace capital assets when they wear out.

The formula for Free Cash Flow Payout is simply Annual Dividend Per Share divided by Free Cash Flow Per Share. I like to see a percentage of 70% or less. The 70% is somewhat higher than many people look for with a traditional payout ratio. I am comfortable with the higher number since we are talking about real cash generated from running the business vs. accounting earnings that may or may not be there. So how do the two ratios compare?

Needless to say, the variances are all over the place. In many companies I looked at the traditional dividend payout ratio was within 10 percentage points higher than a free cash flow payout. This means the GAAP earnings was lower than the calculated Free Cash Flow. Here are some example of this situation:

• Chubb Corp (CB) – Traditional: 28% – FCF Payout: 21% – Analysis
• Clorox Company (CLX) – Traditional: 50% – FCF Payout: 50%
• Emerson Electric Co. (EMR) – Traditional: 53% – FCF Payout: 45% – Analysis
• Family Dollar Stores Inc. (FDO) – Traditional: 25% – FCF Payout: 22%
• Hormel Foods Corp. (HRL) – Traditional: 34% – FCF Payout: 33%
• International Business Machines (IBM) – Traditional: 23% – FCF Payout: 18%
• 3M Co. (MMM) – Traditional: 50% – FCF Payout: 45% – Analysis
• Microsoft Corp. (MSFT) – Traditional: 32% – FCF Payout: 29%
• SYSCO Corporation (SYY) – Traditional: 52% – FCF Payout: 48% – Analysis
• United Technologies Corp. (UTX) – Traditional: 35% – FCF Payout: 30% – Analysis

Sometime the gap is much larger. This could have resulted from significant non-cash charges on the income statement.  Companies with large gaps include:

• Aflac Incorporated (AFL) – Traditional: 44% – FCF Payout: 10% – Analysis
• CenturyLink Inc. (CTL) – Traditional: 87% – FCF Payout: 46%
• Diebold Inc (DBD) – Traditional: 74% – FCF Payout: 30%
• Illinois ToolWorks Inc. (ITW) – Traditional: 76% – FCF Payout: 31% – Analysis
• Leggett & Platt Inc. (LEG) – Traditional: 262% – FCF Payout: 34% – Analysis
• Nucor Corporation (NUE) – Traditional: 88% – FCF Payout: 29% – Analysis
• Pitney Bowes Inc. (PBI) – Traditional: 73% – FCF Payout: 38%
• PPG Inds Inc (PPG) – Traditional: 158% – FCF Payout: 48%
• RLI Corp (RLI) – Traditional: 158% – FCF Payout: 48% – Analysis
• RPM International Inc (RPM) – Traditional: 84% – FCF Payout: 49% – Analysis
• AT&T Inc. (T) – Traditional: 81% – FCF Payout: 49%

Sometimes the gap is not only large, but goes the other way. This is potentially the most dangerous since focusing on the traditional dividend payout may lead you to believe the dividend is covered better than it actually is. Examples of this situation would include:

• Air Products and Chemicals Inc. (APD) – Traditional: 56% – FCF Payout: 172%
• Franklin Resources Inc. (BEN) – Traditional: 23% – FCF Payout: 48%
• BP Plc (BP) – Traditional: 50% – FCF Payout: 114% – Analysis
• Lowe’s Companies, Inc. (LOW) – Traditional: 27% – FCF Payout: 57% – Analysis
• Exxon Mobil Corp (XOM) – Traditional: 27% – FCF Payout: 54%

Although Free Cash Flow Payout is a better payout ratio than the traditional dividend ratio, the investor should look at both and understand the differences. Taking an expense for impairing goodwill is much different than recognizing an expense for losing a lawsuit. The former will not directly involve cash out the door, but the latter will if the company loses on appeal.

Full Disclosure: Long CLX, EMR, MMM, SYY, UTX, AFL, CTL, ITW, NUE, BP. See a list of all my income holdings here.

(Photo Credit)

To gauge how levered a company is, the metric I like to look at is debt to total capital. Debt includes both long-term and short-term debt and is readily available on the liabilities side of the balance sheet. Total capital is a combination of debt and shareholders equity. When you divide debt by total capital a desirable rate is something less than 35%, but I will consider rates up to 50% on a short-term basis.

Many investors look at a return on equity (ROE) when evaluating a company. I have never liked this metric since it ignores debt portion of invested capital. From an ROE approach a highly levered company could show a good return but not be performing well. My preferred return calculation is Free Cash Flow as a percent of Total Capital Employed.

Below are five dividend stocks that with a Debt to Total Capital less than 35%:

Microsoft Corporation (MSFT)- Debt to Capital: 12%- Analysis
Microsoft is the world’s largest software company. It develops PC software, including the Windows operating system and the Office application suite.

AFLAC Inc. (AFL)- Debt to Capital: 24%- Analysis
Aflac Incorporated engages in the marketing and sale of supplemental health and life insurance plans in the United States and Japan.

Nucor Corp. (NUE) – Debt to Capital: 29%- Analysis
Nucor Corporation is engaged in the manufacture and sale of steel and steel products. As the largest minimill steelmaker in the U.S., Nucor has one of the most diverse product lines of any steelmaker in the Americas.

Chevron Corporation (CVX) – Debt to Capital: 9%
Chevron Corporation (formerly ChevronTexaco) is a global integrated oil company that has interests in exploration, production, refining and marketing, and petrochemicals.

Johnson & Johnson (JNJ) – Debt to Capital: 22% – Analysis
Johnson & Johnson engages in the manufacture and sale of various products in the health care field worldwide.

As previously noted, I am currently reworking my dividend analysis worksheets to focus on what’s most important in selecting a dividend stock. A Debt to Total Capital less than 45% , will earn the company a star.

Full Disclosure: Long AFL, NUE, CVX, JNJ. See a list of all my income holdings here.

During the week several big name companies declared dividends, including:

• Safeway (SWY) $0.0828/share – yield 1.87%
• General Mills (GIS) $0.43/share – yield 3.46%
• Microsoft (MSFT) $0.13/share – yield 3.43% – (Analysis)
  
• Heinz (HNZ) $0.415/share – yield 5.40%
  
• Target (TGT) $0.16/share – yielding 2.35% - (Analysis)
• Kraft (KFT) $0.29/share – yield 5.25% - (Analysis)

It is great when companies, like those above, follow through and pay their regular dividends at the appointed time. But it is even more important for companies to follow through and raise their dividend at the appropriate time.  Unfortunately, fewer companies are increasing their dividends. This week there were only two to note:

Piedmont Natural Gas Company Inc. (PNY) is an energy services company that distributes natural gas to 1,016,000 residential, commercial and industrial customers in portions of North Carolina, South Carolina and Tennessee. On March 6th, the company declared a 3.8% increase in its quarterly dividend of $0.27/share. The dividend is payable April 15, 2009, to shareholders of record at the close of business on March 25, 2009. The stock now yields 4.85%. This is the 31st consecutive year PNY has raised its dividend. The company is a dividend Achiever and a dividend Champion.

Warwick Valley Telephone Company (WWVY) provides telephone, Internet and video services to customers in the towns of Warwick, Goshen and Wallkill, New York and West Milford and Vernon townships, New Jersey. On March 10th, the company increased its quarterly cash dividend by 10% to $0.22/share up from $0.20/share. The dividend will be paid on March 31, 2009 to shareholders of record as of March 20, 2009.  Wisner H. Buckbee, Chairman of the Board, said “This dividend increase demonstrates the Board’s confidence in the continued strong performance of WVT’s business, our cash generation capabilities, and our firm commitment to our shareholders.” The stock now yields 9.78%.

For more companies around the world with a long string of consecutive dividend increases, see Dividends Value’s Stock Ideas page.

Full Disclosure: No position in any of the aforementioned securities.

(Photo: Steve Woods)

Linked here is a PDF copy of my detailed analysis of Microsoft Corporation (MSFT). Below are some highlights from the above linked analysis:

Company Description: Microsoft is the world’s largest software company. It develops PC software, including the Windows operating system and the Office application suite.

Fair Value: I consider four calculations of fair value, see page 2 of the linked PDF for a detailed description:

1. Avg. High Yield Price
2. 20-Year DCF Price
3. Avg. P/E Price
4. Graham Number

MSFT is trading at a discount to 1.), 2.) and 3.) above. If I exclude the high and low valuations and average the remaining two, MSFT is trading at a 35.1% discount. MSFT earned a Star in this section since it is trading at a fair value.

Dividend Analytical Data: In this section I consider five factors, see page 2 of the linked PDF for a detailed description:

1. Rolling 4-yr Div. > 15%
2. Dividend Growth Rate
3. Years of Div. Growth
4. 1-Yr. > 5-Yr Growth
5. Payout 15% of avg.

MSFT earned two Stars in this section for 1.) and 2.) above. Rolling 4-yr Div. > 15% means that dividends grew on average in excess of 15% for each consecutive 4 year period over the last 10 years (1998-2001, 1999-2002, 2000-2003, etc.) I consider this a key metric since dividends will double every 5 years if they grow by 15%. MSFT has paid a cash dividend to shareholders every year since 2003 and has increased its dividend payments for 5 consecutive years.

Dividend Income vs. MMA: Why would you assume the equity risk and invest in a dividend stock if you could earn a better return in a much less risky money market account (MMA)? This section compares the earning ability of this stock with a high yield MMA. Two items are considered in this section, see page 2 of the linked PDF for a detailed description:

1. NPV MMA Diff.
2. Years to >MMA

MSFT earned one Star in this section for 1.) above. The NPV MMA Diff. of the $11,718 is in excess of the $10,000 minimum I look for in a stock that has increased dividends as long as MSFT has. If MSFT grows its dividend at 16.3% per year, it will take 9 years to equal the cumulative earnings from a MMA yielding an estimated 20-year average rate of 4.61%. .

Other: MSFT is a member of the S&P 500. MSFT’s ongoing antitrust-related issues is a concern. Open source applications and operating systems may pose a threat. Recently, MSFT to lowered its revenue growth outlook by 5% as a result of weakening business conditions. As a result of releases of Vista, Microsoft Office and Windows Server in prior years, MSFT will face a more difficult year-over-year comp. Losses in its online services will accelerate as the company boosts investments. Risks include lower PC sales, further deterioration in the global economy and not achieving cost synergies from acquisitions.

Conclusion: MSFT earned one Star in the Fair Value section, earned two Stars in the Dividend Analytical Data section and earned one Star in the Dividend Income vs. MMA section for a net total of four Stars. This quantitatively ranks MSFT as a 4 Star-Buy.

Using my D4L-PreScreen.xls model, I determined the share price could increase to $21.03 and MSFT’s NPV MMA Diff. would still be around the $10,000 NPV MMA Diff. that I like to see. At that price the stock would yield 2.19%.

Resetting the D4L-PreScreen.xls model and solving for the dividend growth rate needed to generate the $10,000 NPV MMA Differential I’m looking for, the calculated rate is 15.8%. This dividend growth rate is only slightly below the 16.3% used in this analysis.

If I were interested in initiating a position in MSFT, I would look for a price below $21.03. Currently MSFT is trading above that level, so I would wait to buy on dips. Given its short dividend history, I would be unwilling to purchase shares at a premium.

Disclaimer: Material presented here is for informational purposes only. The above quantitative stock analysis, including the Star rating, is mechanically calculated and is based on historical information. The analysis assumes the stock will perform in the future as it has in the past. This is generally never true. Before buying or selling any stock you should do your own research and reach your own conclusion. See my Disclaimer for more information.

Full Disclosure: At the time of this writing, I held no position in MSFT (0.0% of my Income Portfolio) .

What are your thoughts on MSFT?