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This Model Suggests Royal Mail PLC Could Deliver A 46% Annual Return

If you were one of the lucky few who managed to be allocated shares in the flotation of Royal Mail (LSE: RMG), then congratulations, your shares are already worth 70% more than you paid for them!

If you are one of the many thousands who didn’t get lucky, then you face a more difficult choice: are Royal Mail shares worth buying at today’s price of 563p, or would you earn a better return by putting your money in a FTSE tracker fund?

What will Royal Mail’s total return be?

To answer this question, I need to know the expected total return (capital gains plus dividends) from Royal Mail 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 Royal Mail:

(16.0 ÷ 564 + 0.43 = 0.46 x 100 = 46%

My model suggests that Royal Mail shares could deliver an annual return of 46% next year, massively outperforming the long-term average total return of 8% per year I’d expect from the wider stock market (and from a FTSE 100 tracker).

However, this figure does need to be taken with a pinch of salt, as it may have been distorted by the unusual circumstances.

Current forecasts suggest that this year’s 16p payment may rise by 43% to 23p next year — a rate of increase that will not be sustainable for more than a year or two, and may not happen at all.

If Royal Mail increases its dividend by a more modest amount next year, then the expected returns from Royal Mail shares will be lower; a 15% dividend increase would equate to an expected total return of 18%.

Can Royal Mail afford it?

I like to test the affordability of a company’s dividend by comparing it to its free cash flow per share:

Free cash flow = operating cash flow – tax – capital expenditure – net interest

Royal Mail’s 2012/13 accounts showed that it generated a healthy 49p of free cash flow per share last year, suggesting that this year’s 16p dividend is likely to be comfortably affordable, and that a significant dividend hike next year might also be possible.

A share to retire on?

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> Roland does not own shares in Royal Mail.