Does AstraZeneca 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 AstraZeneca (LSE: AZN) (NYSE: AZN.US).

The triple yield test

Today’s low cash saving and government bond rates mean that 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 trailing yield figures –the dividend, earnings and free cash flow yields. I call this my triple yield test:

AstraZeneca Value
Current share price 3,856p
Dividend yield 4.4%
Earnings yield 8.4%
Free cash flow yield 4.4%
FTSE 100 average dividend yield 3.0%
FTSE 100 earnings yield 6.0%
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. Astra’s earnings yield of 8.4% is comfortably above the FTSE 100 average, but it masks a problem — the pharmaceutical firm’s earnings are expected to continue falling for at least another year.

Analysts’ consensus forecasts indicate earnings of $4.98 per share for 2013, and $4.54 per share for 2014, equating to P/E ratios of 12.8 and 14.0 respectively. In my view, this earnings outlook suggests Astra’s shares are already fully valued.

Although Astra’s dividend yield remains attractive, it’s worth noting two points: firstly, the firm’s dividend has been virtually flat since 2011, and secondly, Astra’s dividend was only just covered by its free cash flow last year.

Set against a backdrop of declining earnings and rising capital expenditure on acquisitions and research, Astra’s dividend is beginning to look less affordable. I don’t expect to see much, if any, dividend growth for at least another year, leaving the shares’ income lagging behind inflation.

Is Astra a buy?

I’ve previously rated Astra as good value, but the firm’s shares have gained 16% over the last three months, despite its poor earnings outlook.

My current view is that Astra deserves a hold rating. For new investors, I believe there is better value elsewhere, but existing holders should probably sit tight, as I am confident the firm’s low gearing and strong cash reserves should enable it to weather the fallout from the patent cliff, without cutting its dividend, or otherwise punishing shareholders.

The dividend test

Astra's dividend was barely covered by free cash flow last year, and has not risen significantly since 2011 -- two classic warning signs of a possible dividend cut. Although I don't expect this to happen, I could be wrong.

If you hold shares in AstraZeneca, I strongly recommend you take a look at the five 'golden dividend rules' included in "How To Create Dividends For Life".

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> Roland does not own shares in AstraZeneca.