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 Banco Santander (LSE: BNC) (NYSE: SAN.US), for example. The firm’s 8.4% prospective yield is very attractive, as it matches the long-term average total return from UK equities of 8%, without requiring any capital gains.
However, a very high yield usually means extra risk. In Santander’s case, the dividend, which has been unchanged for five years, is substantially higher than the bank’s expected earnings per share for 2013-14. An uncovered dividend is generally frowned up, and analysts are expecting cuts.
(I’ve calculated the prospective yield based on the €0.60 annual payout, less 6% withholding tax — Spanish dividends are taxed at 21%, and you will only get 15% credited back in the UK).
What will Santander’s total return be?
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 long-term rate of total return on a dividend-paying share:
Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate
Here’s how this formula looks for Santander:
(47 ÷ 553) – 0.19 = -0.11 x 100 = -11%
Analysts’ consensus forecasts currently suggest that Santander’s dividend could be cut by nearly 20% in 2014, as the bank seeks to bring the dividend back into line with earnings.
If this happens, my model suggests that Santander’s long-term returns could turn negative, as its share price would be likely to fall: Santander shares currently trade at around 17 times the bank’s forecast 2013 earnings, compared to less than 12 for its global peer, HSBC Holdings.
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 its dividend.
I normally look at free cash flow to test dividend affordability, but Santander has taken a different approach, and the majority of its shareholders receive their dividends as scrip dividends — i.e. new shares (although there is still a cash option).
This approach comes at the expense of shareholder dilution each time a dividend is paid, but has enabled Santander to pay a generous dividend through the worst financial crisis since the Great Depression, while simultaneously rebuilding its reserves.
Testing Santander’s dividend
Although analysts are forecasting a dividend cut from Santander, they won’t necessarily be right. Santander’s scrip dividend programme means that cash outflow from dividends is relatively low, and the bank might decide to maintain its generous approach to shareholder payouts.
