This Model Suggests SSE PLC Could Deliver An 11.1% 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 SSE (LSE: SSE) (NASDAQOTH: SSEZY.US), for example. The firm’s 6.6% prospective yield is seriously attractive, but SSE’s share price has fallen by 15% over the last three months, wiping out any dividend returns and leaving investors looking at an uncertain future.

What will SSE’s total return be?

As a SSE shareholder, I’m tempted to top up my holding and improve my yield on cost, but I need to have some idea of the likely total return — capital gains plus dividends — from SSE over the next few years.

Can the UK’s third-largest utility outperform the long-term average total return of 8% I’d expect from 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 SSE:

(87.9 ÷1334) + 0.045 = 0.111 x 100 = 11.1%

My model suggests that SSE shares could deliver an annual total return of 11.1% 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 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

SSE’s free cash flow was a rather feeble £86m last year — nowhere near enough to cover the £515m it paid in dividends. That means it had to rely on reserves — previously saved profits — to pay shareholders.

The situation looks likely to be similar this year, highlighting how stretched SSE’s cash flow is. However, the firm’s 14-year unbroken history of above-inflation dividend growth suggests that it will find a way of maintaining its payout to shareholders.

The FTSE's top income stock?

SSE's income credentials are certainly impressive, but there is another utility stock that the Motley Fool's analysts rate even more highly.

The company in question currently offers an inflation-linked 5.4% prospective yield, and was recently named as "Today's Top Income Buy" by the Fool's expert analysts, who believe this dividend legend may currently be undervalued by around 10%.

I can't reveal the identity of this stock here, but for full details of the company concerned, click here to download your free copy of this income report immediately, while it's still available.

> Roland owns shares in SSE.