This Model Suggests The FTSE 100 Could Deliver A 6.4% Annual Return

In a recent series of articles, I have been modelling the annual returns that may be available from a number of popular dividend-paying stocks, such as Marks & Spencer and Vodafone. However, for these forecasts to be meaningful, we need to know the expected return from the FTSE 100, which many investors use as a benchmark for their own portfolios.

The FTSE100 (FTSEINDICES: ^FTSE) currently offers a forecast yield of 3.1%; 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 can the FTSE add to the 11% rise it’s delivered so far this year?

What will FTSE’s total return be?

Looking ahead, I need to know the expected total return from the FTSE 100, in order to compare it to the expected performance of my portfolio.

The dividend discount model is a technique that’s widely used to value dividend-paying shares, but it can also be applied to an index, as long as the majority of the index’s members pay consistent dividends.

A variation of this model also allows you to calculate the expected rate of return on a dividend-paying share or index:

Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate

Here’s how this formula looks for the FTSE 100:

(207.6 ÷ 6697) + 0.033 = 0.64 x 100 = 6.4%

My model suggests that the FTSE 100 could deliver a 6.4% annual return over the next few years, slightly below the long-term average return from UK equities of 8%. This suggests that the FTSE 100’s current valuation is slightly above average, but only by a small amount.

In my view, a 6.4% return is attractive, and the FTSE’s current valuation is close enough to average levels to make it a reasonably safe buy, at its current price.

Can we beat the FTSE?

As an active investor, I believe it’s possible to beat the 6.4% that’s on offer from the FTSE 100. My model suggests that a number of FTSE 100 stocks currently offer better returns than the index as a whole.

For example, my calculations suggest that Vodafone could deliver an annual return of 11.1% over the next few years, while Unilever may offer 10.6%, Aviva could generate 10.4%, and Royal Bank of Scotland Group could deliver a staggering 51% total return!

How to outperform the FTSE

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> Roland owns shares in Vodafone, Unilever and Aviva, but does not own shares in any of the other companies mentioned in this article. The Motley Fool has recommended Unilever and Vodafone.