One of the risks of being an income investor, is that you can be seduced by attractive yields, that are sometimes a symptom of a declining business or falling share price.
Take Vodafone Group (LSE: VOD) (NASDAQ: VOD.US), for example. The firm’s 4.8% yield is attractive but, equally, 4.8% is substantially less than the long-term average return from UK equities, which is about 8%.
Vodafone’s share price has already risen by 47% this year, and if the firm’s European business continues to tread water, I could find that my dividend income is being cancelled out by a falling share price.
What will Vodafone’s total return be?
Looking ahead, I need to know the expected total return from my Vodafone shares, so that I can compare them to my benchmark, a FTSE 100 tracker.
The dividend discount model is a technique that’s widely used to value dividend-paying shares. A variation of this model also allows you to calculate the expected rate of return on a dividend paying share:
Total return = (Last year’s dividend ÷ current share price) + expected dividend growth rate
Rather than guess at future growth rates, I usually use the average dividend growth rate from the last five years. Here’s how this formula looks for Vodafone — I’ve used 11p as the dividend, as the firm’s management has already committed to this payment for the current financial year:
(11 / 228) + 0.063 = 0.111 x 100 = 11.1%
This model suggests that Vodafone shares could deliver a total return of 11.1% per year over the next few years, meaning that there is a good chance they will outperform my long-term average target of 8% total return per year, before inflation.
Isn’t this too simple?
One limitation of this formula is that it doesn’t tell you whether a company can afford to keep paying and growing its dividend. My preferred measure of dividend affordability is free cash flow — the cash that’s left after capital expenditure, tax and interest costs.
Free cash flow is normally defined as operating cash flow – tax – capex. Vodafone’s 2012/13 results show that only 6.9p of last year’s 10.2p dividend payment was covered by free cash flow.
This is a potential red flag, but it’s normal for free cash flow cover to vary depending on capex commitments, and historically, Vodafone’s dividends have mostly been covered by free cash flow.