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This Model Suggests Vodafone Group plc Could Deliver An 11.1% Annual Return

One of the risks of being an income investor, is that you can be seduced by attractive yields, that are sometimes a symptom of a declining business or falling share price.

Take Vodafone Group (LSE: VOD) (NASDAQ: VOD.US), for example. The firm’s 4.8% yield is attractive but, equally, 4.8% is substantially less than the long-term average return from UK equities, which is about 8%.

Vodafone’s share price has already risen by 47% this year, and if the firm’s European business continues to tread water, I could find that my dividend income is being cancelled out by a falling share price.

What will Vodafone’s total return be?

Looking ahead, I need to know the expected total return from my Vodafone 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 = (Last year’s dividend ÷ current share price) + expected dividend growth rate

Rather than guess at future growth rates, I usually use the average dividend growth rate from the last five years. Here’s how this formula looks for Vodafone — I’ve used 11p as the dividend, as the firm’s management has already committed to this payment for the current financial year:

(11 / 228) + 0.063 = 0.111 x 100 = 11.1%

This model suggests that Vodafone shares could deliver a total return of 11.1% per year over the next few years, meaning that there is a good chance they will outperform my long-term average target of 8% total return per year, before inflation.

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, tax and interest costs.

Free cash flow is normally defined as operating cash flow – tax – capex. Vodafone’s 2012/13 results show that only 6.9p of last year’s 10.2p dividend payment was covered by free cash flow.

This is a potential red flag, but it’s normal for free cash flow cover to vary depending on capex commitments, and historically, Vodafone’s dividends have mostly been covered by free cash flow.

A share to retire on?

Vodafone's financial situation will change when the sale of its stake in Verizon Wireless completes next year, but I believe it will remain an attractive buy and hold share.

However, if you are looking for alternative ideas for your retirement portfolio, I would strongly recommend taking a look at five FTSE 100 companies the Motley Fool's team of analysts have identified as potential retirement shares.

You can find full details of all five in the Fool's latest free report, "5 Shares To Retire On" -- just click here to download your copy now.

> Roland owns shares in Vodafone Group but does not own shares in any of the other companies mentioned in this article. The Motley Fool has recommended shares in Vodafone.