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 Rio Tinto (LSE: RIO) (NYSE: RIO.US), for example. This giant miner’s 3.4% prospective yield is slightly above the FTSE 100 average of 3.2%, but it is substantially less than the long-term average annual total return from UK equities, which is about 8%.
Total return is made up of dividend yield and share price growth combined — but Rio’s share price has lagged the FTSE, and is down by 11.6% so far this year, compared to an 11.6% gain for the index. Can Rio recover this lost ground, and deliver an above-average total return?
What will Rio Tinto’s total return be?
Looking ahead, I need to know the expected total return from my Rio Tinto 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
Here’s how this formula looks for Rio Tinto:
(1.12 ÷ 32.48) + 0.075 = 0.109 x 100 = 10.9%
My model suggests that Rio shares could deliver a total return of 10.9% per year 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 operating cash flow that’s left after capital expenditure, tax costs and interest payments.
Free cash flow = operating cash flow – tax – capital expenditure – net interest
Rio’s free cash flow was -£8.4bn last year, thanks to a hefty investment programme and a big fall in income. However, I don’t think this is a major cause for concern as previous years show strong free cash flow cover for the firm’s dividend, and Rio’s gearing remains a relatively modest 48.9%, despite increases in net debt over the past three years.