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 BP (LSE: BP) (NYSE: BP.US), for example. The firm’s 4.8% prospective yield is attractive, but 4.8% is still substantially less than the long-term average total return from UK equities, which is about 8%.
BP still faces the prospect of fines for its Gulf of Mexico oil spill that could range from around $5bn to more than $20bn. In a worst-case ruling, the firm’s share price could be adversely affected, dragging its total return — capital gains plus dividends — down below the FTSE average.
What will BP’s total return be?
Looking ahead, I need to know the expected total return from BP 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 BP:
(22.9 ÷ 483) + 0.117 = 0.164 x 100 = 16.4%
My model suggests that BP shares could deliver an annual total return of 16.4% over the next few years — more than double the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
The firm’s aggressive dividend growth, share buybacks and strong profits have convinced the markets that it can weather the outcome of its legal battles, and that a worst-case ‘gross negligence’ oil spill ruling is unlikely.
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
BP’s free cash flow totalled just £639m last year, despite the firm generating net cash from operating activities of more than £20bn. BP’s hefty tax and capex bills accounted for most of the remainder, leaving its £5.3bn dividend payout almost totally uncovered by cash flow.