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Does SSE 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 SSE (LSE: SSE) (NASDAQOTH: SSEZY.US).

The triple yield test

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:

SSE Value
Current share price 1,322p
Dividend yield 6.4%
Earnings yield 8.5%
Free cash flow yield 2.6%
FTSE 100 average dividend yield 2.9%
FTSE 100 earnings yield 5.8%
Instant access cash savings rate 1.5%
UK 10yr govt bond yield 2.8%

A share’s earnings yield is simply the inverse of its P/E ratio, and makes it easier to compare a company’s earnings with its dividend yield. SSE’s earnings yield of 8.5% is substantially above the FTSE 100 average, as is its 6.4% dividend yield.

However, I believe that SSE’s dividend yield has now risen so high that it needs to be considered as a possible warning of trouble ahead. This potential problem is highlighted by SSE’s free cash flow yield, which is just 2.6%.

Free cash flow yield shows how much a company could pay in dividends, if it paid out the surplus cash generated after capital expenditure, taxes and interest payments. SSE is not generating enough cash to fund its dividend, which must therefore be coming out of the utility’s reserves and borrowings.

Falling consumption

Consumers’ average energy consumption has fallen in recent years; in its most recent trading update, SSE said that electricity consumption had fallen by 4.3% over the last year, while gas consumption had dropped by 9.5%. Utilities like SSE have become dependent on above-inflation price increase to prop up their profits, a practice that has made them increasingly unpopular with consumers.

Energy prices could become an issue in the 2015 general election, and if the next government decides to crack down on this practice, then I believe SSE could be forced to cut its dividend, and perhaps even raise funds through a rights issue.

In my view, SSE shares are cheap enough to rate a buy at the moment — but don’t expect that 6%+yield to last forever.

A safer choice?

Although I can see trouble ahead for SSE, there is one utility that I believe provides a far safer way to play the UK utility market, and currently offers a 5.3% prospective yield.

I can't reveal the name here, but I can say that the Motley Fool's expert analysts agree with my choice, and recently selected the company for their exclusive special report, "5 Shares To Retire On".

The five companies included in the report currently offer an average prospective yield of 4.2%. For instant access to your free copy of this report, just click here.

> Roland owns shares in SSE.