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 BAE Systems (LSE: BA) (NASDAQOTH: BAESY.US), for example. The firm’s 4.6% prospective yield is attractive, but, 4.6% is still substantially less than the long-term average total return from UK equities, which is about 8%.
Total return is made up of dividend yield and share price growth combined — but as BAE’s share price has already climbed by 40% over the last year, is there any upside left for new investors?
What will BAE’s total return be?
Looking ahead, I need to know the expected total return from my BAE 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 BAE Systems:
(20.2 ÷ 434) + 0.0381 = 0.0846 x 100 = 8.5%
My model suggests that BAE shares could deliver a very average 8.5% annual total return over the next few years, broadly matching the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
This suggests that BAE is trading close to its fair value, although the firm’s above-average yield and low forecast P/E of 10.0 — considerably below the FTSE 100 average of 14.5 — still look attractive to me.
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
BAE’s free cash flow last year was a mighty £2.1bn, covering the firm’s £620m dividend payout by more than three times. Although last year was exceptional, BAE has a solid track record of paying dividends that are covered by cash flow, making it a fairly safe income stock.