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This Model Suggests BAE Systems plc Could Deliver An 8.5% 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 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.

A share to retire on?

BAE's income credentials have earned it a place in my retirement portfolio, but the defence giant didn't make the cut when the Motley Fool's analysts recently chose 5 stocks for their latest special report, "5 Shares To Retire On".

All five shares offer high-quality income and long-term growth potential, and at the time of writing, the five companies together offered an average prospective yield of 4.1%, 30% higher than the FTSE 100 average.

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> Roland owns shares in BAE Systems.