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 Direct Line Insurance Group (LSE: DLG), for example. The firm’s 5.5% prospective yield is attractive, but 5.5% is substantially less than the long-term average total return from UK equities, which is about 8%.
Total return is made up of dividend yield and share price growth combined — but will Direct Line deliver any capital gains for shareholders over the next few years, or is it already priced to perfection, after climbing 16% last year?
What will Direct Line’s total return be?
Looking ahead, I need to know the expected total return from Direct Line 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 Direct Line:
(13.5 ÷ 246) + 0.006 = 0.61 x 100 = 6.1%
Direct Line outperformed the FTSE 100 by 6% last year, and my model suggests that its shares are now fully priced, and could underperform the wider market if purchased at their current price.
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
Direct Line’s cash flow has nose-dived this year, thanks to a collapse in investment returns, which fell from £2.2bn during the second half of 2012 to just £74m during the same period last year. As a result, the insurer’s free cash flow for the last twelve months is -£1.0bn.
Direct Line has also reported a 4.3% fall in gross written premiums during the first nine months of this year, and although analysts’ consensus forecasts suggest that earnings per share will be around 6% higher than last year, near-term dividend growth seems unlikely.
