One of the risks of focusing on dividends is that you may sometimes focus too heavily on historic yields, and miss out on opportunities for strong future growth.
Take ARM Holdings (LSE: ARM) (NASDAQ: ARMH.US), for example. The firm’s 0.6% prospective yield is hopeless for income investors, but ARM’s shares have outperformed the FTSE 100 consistently over the last ten years, during which they have delivered an average annual total return of almost 25%, compared with 8.4% from the FTSE 100.
What will ARM’s total return be?
Looking ahead, I need to know the expected total return — capital growth plus dividends — from my ARM 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 ARM:
(5.52 ÷ 950) + 0.227 = 0.227 x 100 = 23.2%
My model suggests that ARM shares could provide annual return of 23.2% over the next few years, outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker by a large margin.
In this case, ARM’s dividend growth rate — which has averaged 17.6% since 2007 — may be skewing the result from this model too favourably — but who knows?
ARM shares have gained 897% over the last five years, but currently trade on a lower P/E rating than they have done for some time, thanks to surging profits and a substantial net cash balance.
ARM may continue to grow, and the firm’s cash-generative royalty-based business model means that additional sales translate directly into higher profits — ARM’s operating margin was 36% in 2012.
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
ARM’s free cash flow was £80.7m in 2012, comfortably covering the £51.8m it paid out in shareholder dividends.
