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This Model Suggests Rio Tinto plc Could Deliver A 10.9% Annual Return

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.

Is Rio a retirement share?

I hold Rio Tinto shares in my retirement portfolio, but they didn't make the grade when the Motley Fool's analysts selected five top dividend growth stocks for their latest special report, "5 Shares To Retire On".

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> Roland owns shares in Rio Tinto.