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 Unilever (LSE: ULVR) (NYSE: UL.US), for example. The firm’s 3.6% prospective yield is above average, but, 3.6% is substantially less than the long-term average total return from UK equities, which is about 8%.
Total return is made up from dividends and share price gains, but Unilever’s share price has fallen by 10% over the last six months, and the firm has lagged the FTSE over the last year, rising by just 7%, compared to 17% for the index.
Adverse exchange rate fluctuations, weak growth in Europe and the US, and slowing emerging market growth have been blamed for Unilever’s slowing growth, but it’s still gaining market share in most markets. I believe Unilever will continue to be a solid long-term investment.
What will Unilever’s total return be?
Looking ahead, I need to know the expected total return from my Unilever 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 Unilever:
(88.7 ÷ 2473) + 0.0703 = 0.106 x 100 = 10.6%
My model suggests that Unilever shares could deliver an annual return of 10.6% over the next few years, outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
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.
Using this definition, Unilever generated £4.4bn of free cash flow last year, comfortably exceeding the £2.7bn it paid in dividends.Â