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 Centrica (LSE: CNA) (NASDAQOTH: CPYYY.US), for example. The firm’s 4.9% prospective yield is attractive, but 4.9% is substantially less than the long-term average total return from UK equities, which is about 8%.
Will Centrica’s share price — which has lagged the FTSE 100 and returned just 5% this year — deliver the long-term gains needed to beat my target 8% return?
What will Centrica’s total return be?
Looking ahead, I need to know the expected total return from Centrica 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 = (Prospective dividend ÷ current share price) + expected dividend growth rate
Rather than guess at future growth rates, I usually average dividend growth between 2009 and the current year’s forecast payout, to provide a more reliable guide to the underlying trend. Here’s how this formula looks for Centrica:
(17.3 ÷353) + 0.078 = 0.127 x 100 = 12.7%
My model suggests that Centrica shares could deliver a 12.7% annual total return over the next few years, comfortably outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
Long-term planning, like yesterday’s 4-year, £4.4bn LNG deal with Qatargas, should help ensure that Centrica’s business remains protected from short-term supply fluctuations that could knock its profits.
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.
Centrica’s free cash flow was only £523m last year, and didn’t cover the £815m is paid out to shareholders in dividends. However, averaged over the last two years, Centrica’s free cash flow has covered its dividend, which suggests that the firm’s rising dividend remains affordable and is likely to continue to grow.