One of the risks of being an income investor is that you can be seduced by attractive yields, which are sometimes a symptom of a declining business or a falling share price.
Take Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US), for example. The firm’s 4.9% prospective yield is well above the FTSE 100 average of 3%, but 4.9% is substantially less than the long-term average total return from UK equities, which is about 8%.
Shell’s share price has underperformed the FTSE 100 by 13% over the last 12 months, wiping out the return provided by its dividends.
Will Shell’s underperformance continue?
Looking ahead, I need to know the expected total return from my Shell 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 since 2009, to capture a firm’s dividend growth since the financial crisis. Here’s how this formula looks for Shell:
(1.072 ÷ 22.8) + 0.0079 = 0.549 x 100 = 5.49%
This model indicates that Shell shares could deliver an annual return of around 5.5% over the next few years, suggesting that there is a good chance they will continue to underperform my long-term annual target of 8%.
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 and tax costs.
Free cash flow is normally defined as operating cash flow – tax – capex.
Applying this formula to Shell’s 2012 accounts shows that Shell’s free cash flow was -$12bn last year, leaving its dividend uncovered.
Although this isn’t ideal, Shell’s low debt levels and strong balance sheet mean that its dividend isn’t at immediate risk. What’s more, I expect to see the firm’s cash flow position steadily improve over the next few years, as Shell’s incoming CEO, Ben van Beurden, is expected to focus on improving shareholder returns, rather than growth at any cost.