This Model Suggests Diageo plc Could Deliver A 9.3% Annual Return

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 Diageo (LSE: DGE) (NYSE: DEO.US), for example. The firm’s 2.3% yield is below average, but it is backed by a 14-year continuous run of dividend increases, which have seen the firm’s annual payout rise by 143%, from 19.5p in 1999, to 47.4p in 2013.

If Diageo can continue growing its dividend in this fashion, then it might be worth accepting a below-average yield now, in order to tap into future dividend growth.

What will Diageo’s total return be?

Looking ahead, I need to know the expected total return from Diageo shares, so that I can compare them to my benchmark of 8%, which is the long-term average return on UK equities.

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 = (Last year’s dividend ÷ current share price) + expected dividend growth rate

Rather than guess at future growth rates, I usually use the average dividend growth rate since 2009, to capture a firm’s dividend growth since the financial crisis. Here’s how this formula looks for Diageo:

(47.4 / 2034) + 0.070 = 0.933 x 100 = 9.33%

This model suggests that Diageo shares could deliver an annual return of 9.3% over the next few years, slightly ahead of my 8% target.

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.

Diageo’s 2012/13 results show that free cash flow was £1,227m last year, while the firm paid out a total of £1,236m in dividends.

This suggests to me that Diageo is already paying dividends at close to the maximum sustainable level.

Although Diageo enjoys an attractive operating margin of 22%, its 118% gearing is quite high. In my view, Diageo remains quite expensive, and its expected returns are not sufficiently greater than those available from a tracker fund to persuade me to invest.

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> Roland does not own shares in Diageo.