This Model Suggests GlaxoSmithKline plc Could Deliver An 11% Annual Return

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 the UK’s largest pharmaceutical firm, GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US), for example. The firm’s 4.7% prospective yield is attractive, but, 4.7% 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 Glaxo shares are already up by 23% this year, and the firm is facing corruption allegations in China that triggered a 9% fall in Asian sales during the third quarter. Can Glaxo overcome these headwinds to deliver capital growth?

What will Glaxo’s total return be?

Looking ahead, I need to know the expected total return from my Glaxo 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

Rather than guess at future growth rates, I usually average dividend growth between 2009 and the current year’s forecast payout, to provide a more reliable guide to the underlying trend. Here’s how this formula looks for Glaxo:

(77.8 ÷ 1645) + 0.063 = 0.110 x 100 = 11.0%

My model suggests that Glaxo shares could deliver a 11% total return over the next few years, outperforming 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.

In Glaxo’s case, the firm’s 2012 free cash flow of £1,744m was insufficient to cover its £3,814m dividend payments, but this is the exception — from 2011 back to at least 2007, Glaxo’s dividend has been amply covered by free cash flow.

An alternative to Glaxo?

Despite the appeal of Glaxo's dividend, I am concerned about its £15bn net debt, and I believe there are better choices elsewhere for income investors, including one company that's been named by the Motley Fool's analysts as "Today's Top Income Buy".

The company concerned currently offers an inflation-linked, 5.5% dividend yield, and the Fool's analysts believe it is currently trading at almost 10% below its fair value.

For full details of the company concerned, click here to download your free copy of this report immediately, as availability is strictly limited.

> Roland owns shares in GlaxoSmithKline.