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 AstraZeneca (LSE: AZN) (NYSE: AZN.US), for example. The firm’s 5.2% prospective yield is attractive, but, 5.2% is substantially less than the long-term average total return from UK equities, which is about 8%.
AstraZeneca’s earnings are expected to continue to fall next year, meaning that the firm is in the unattractive situation of looking more expensive in the future than it does today. Investors are dependent on the firm’s management turning around this decline to support future share price growth — otherwise Astra’s dividend yield could be cancelled out by a falling share price.
What will AstraZeneca’s total return be?
Looking ahead, I need to know the expected total return from AstraZeneca 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 AstraZeneca:
(1.755 ÷ 32.86) + 0.01 = 0.063 x 100 = 6.3%
My model indicates that AstraZeneca shares could deliver a 6.3% annual return over the next few years, suggesting that they may underperform 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 cash that’s left after capital expenditure and tax costs.
Free cash flow is normally defined as operating cash flow – tax – capex.
Despite its falling earnings, Astra has low debt levels and remains very profitable. The pharmaceutical firm’s £3.7bn dividend payout in 2012 was generously covered by free cash flow of £5.6bn.
I believe Astra’s desirable dividend will remain safe, but the timing of the firm’s turnaround is less certain and the firm’s share price could underperform the market in the meantime, as investors become wary of paying too much for falling future earnings.
