This Model Suggests Aviva plc Could Deliver A 10.4% 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 Aviva (LSE: AV) (NYSE: AV.US), for example. Broker consensus forecasts suggest that the firm offers a 3.6% prospective yield, which is attractive. But 3.6% is substantially less than the long-term average total return from UK equities, which is about 8%.

Aviva’s share price has risen by 32% over the last 12 months and is close to its post-2008 high. Can it keep rising to enhance Aviva’s total return?

What will Aviva’s total return be?

Looking ahead, I need to know the expected total return from my Aviva shares, so that I can compare it 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

Last year’s 40% dividend cut means my usual averaged dividend growth approach will give a heavily skewed result, so I ‘ve calculated Aviva’s potential returns using next year’s forecast dividend growth. Here’s how this formula looks for Aviva:

(15.5 ÷435) + 0.0685 = 0.104 x 100 = 10.4%

My model suggests that Aviva shares could deliver a total return of 10.4% per year over the next few years, modestly 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 model 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.  One of the reasons that Aviva cut its dividend last year was to improve cash flow — a prudent objective I approve of, albeit uncomfortable for shareholders like me.

Free cash flow is normally defined as operating cash flow – tax – capex.

Aviva’s free cash flow in 2012 was £2.2bn, comfortably covering its £647m payout. However, free cash flow was boosted by the proceeds of asset sales and fund raising, without which the firm’s cash flow would have been much tighter.

Today's top income choice?

In my view, Aviva remains an attractive income share, but I am not convinced that now is the best time to buy. I think there are better options available elsewhere, including one company that's been named by the Motley Fool's analysts as "Today's Top Income Buy".

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

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> Roland owns shares in Aviva.