This Model Suggests BP plc Could Deliver A 16.4% 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 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.

Is BP a share to retire on?

BP's income credentials have made it popular with income investors, but the oil giant didn't make the cut when the Motley Fool's analysts recently chose five 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.