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 British American Tobacco (LSE: BATS) (NYSE: BTI.US), for example. The firm’s 4.3% prospective yield is attractive, but, 4.3% is substantially less than the long-term average total return from UK equities, which is about 8%.
BAT’s share price is up by 8.7% so far this year, somewhat underperforming the FTSE 100’s 10.8% gain. Will BAT’s performance continue to keep pace with the index, or will this cigarette manufacturer’s declining sales gradually erode its valuation?
What will BAT’s total return be?
Looking ahead, I need to know the expected total return from British American Tobacco 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 British American Tobacco:
(143.2 ÷3298) + 0.0613 = 0.105 x 100 = 10.5%
My model suggests that BAT shares could deliver an annual total return of 10.5% over the next few years, modestly 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
BAT’s free cash flow last year was a whopping £3.5bn, comfortably covering the £2.8bn it paid out in dividends.
Although BAT’s sales are likely to continue to decline, its 35% operating margin, ongoing share buybacks and pricing power means that the tobacco giant is expected to continue growing its dividend by around 6% per year for the foreseeable future.
In my view, BAT remains a sensible income investment, but its long-term prospects are less certain, and I’m not sure it offers the long-term growth and reliable income I want for my retirement portfolio.