One of the risks of being an income investor is that you may sometimes focus too heavily on historic yields, and miss out on opportunities for strong future growth.
Take Barclays (LSE: BARC) (NYSE: BCS.US), for example. The firm’s 2.4% prospective yield is below average, but the bank is only just starting to exit its recovery phase, and analysts’ consensus forecasts suggest that its dividend could rise to 10.9p in 2014 — equating to a yield of 4.2% at today’s share price.
What will Barclays’ total return be?
Looking ahead, I need to know the expected total return (dividend + share price growth) from Barclays shares, so that I can compare them to my benchmark, a FTSE 100 tracker.
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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
Rather than guess at future growth rates, I usually average dividend growth between 2009 and the current year’s forecast payout, to provide a more reliable guide to the underlying trend. Here’s how this formula looks for Barclays:
(6.17 ÷ 258) + 0.278 = 0.302 x 100 = 30.2%
My model suggests that Barclays shares could deliver a staggering 30% annual return, massively outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
This projected growth is based on the assumption that Barclays’ business — along with its share price and dividend — will continue to recover strongly. As with any investment offering high returns, it carries additional risk.
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 and tax costs.
Free cash flow is normally defined as operating cash flow – tax – capex.
Barclays reported a loss last year, so its dividend was not covered by cash flow or earnings, but this year is expected to be different, with analysts forecasting earnings of 26.2p per share. However, until the bank’s results are published in 2014, we won’t know whether this progress is reflected in Barclays’ free cash flow.
