Does GlaxoSmithKline plc Pass My Triple Yield Test?

Like most private investors, I drip feed money from my earnings into my investment account each month. To stay fully invested, I need to make regular purchases, regardless of the market’s latest gyrations.

However, the FTSE’s gains mean that the wider market is no longer cheap, and it’s getting harder to find shares that meet my criteria for affordability.

In this article, I’m going to run my investing eye over GlaxoSmithKline (LSE: GSK) (NYSE: GSK.US). The pharma giant outperformed the FTSE 100 last year, but has lagged behind the index since 2009, gaining 35%, compared to 65% for the FTSE. This could mean that Glaxo shares still offer good value for new buyers.

The triple yield test

It’s worth remembering that the real test of an income investment is the return — or yield — it provides, relative to the level of risk it entails and the comparative returns available elsewhere.

Today’s low cash saving and government bond rates mean that high-yielding shares have become some of the most attractive income-bearing investments available.

To gauge the affordability of a share for my income portfolio, I like to look at three key yield figures — the dividend, earnings and free cash flow yields. I call this my triple yield test:

GlaxoSmithKline Value
Current share price 1,671p
Dividend yield 4.6%
Earnings yield 6.9%
Free cash flow yield 5.3%
FTSE 100 average dividend yield 2.9%
FTSE 100 earnings yield 5.7%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.8%

A share’s earnings yield is simply the reverse of its P/E ratio, and makes it easier to compare a company’s earnings with its dividend yield. An earnings yield of 10% equates to a P/E of 10, while a yield of 5% is equivalent to a P/E of 20.

Glaxo’s 6.9% earnings yield isn’t a screaming bargain, but it is cheaper than the FTSE 100 average, and is backed by a generous dividend and strong free cash flow generation.

Glaxo shares currently boast a free cash flow yield of 5.3%, which provides an indication of the maximum dividend yield that would be possible if Glaxo paid out all of its surplus cash from the last twelve months. Of course, few companies are likely to do this, as they need to preserve some cash for leaner years in the future. Glaxo’s 4.6% dividend yield is therefore quite generous, and is higher than both the FTSE 100 average, and the rates available from cash savings and gilts.

In my view, Glaxo’s high dividend yield and strong free cash flow mean that the firm’s shares remain attractively priced for new investors, and deserve a buy rating.

The best pharma dividend?

City forecasts suggest that Glaxo will increase its fourth-quarter dividend by 4.1% to 22.9p this year, placing the firm's shares on a prospective yield of 4.7%.

If you're tempted to hit the buy button, then you may be interested to know that Glaxo was recently selected by the Motley Fool's analysts for an exclusive special report, "Five Shares To Retire On".

The five shares in the report offer an average yield of more than 4% and are all world-class companies -- for instant access to your copy of this free report, just click here now.

Roland owns shares in GlaxoSmithKline. The Motley Fool has recommended GlaxoSmithKline.