Does BHP Billiton 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 commodities giant BHP Billiton (LSE: BLT) (NYSE: BBL.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 yield figures — the dividend, earnings and free cash flow yields. I call this my triple yield test:

BHP Billiton Value
Current share price 1,800p
Dividend yield 4.2%
Earnings yield 7.7%
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. BHP’s earnings yield of 7.7% reflects its trailing P/E rating of 13, which is below the FTSE average, but at the upper end of valuations for the mining sector.

Dividend hero

This valuation seems justified by BHP’s yield, however, which at 4.2% is one of the best in its sector. BHP’s dividend is affordable, too — it was covered by the firm’s free cash flow yield of 4.4% in 2012/13, despite BHP’s net capex of $17.8bn.

A further point in favour of BHP is its long history of above-inflation dividend growth. BHP’s dividend has risen by an impressive average of 16.8% per year since 1998; the firm’s 2012 payout was more than twelve times its 1998 payout.

BHP’s dividend is expected to rise by a more modest 4.7% this year, but shareholders should note that because the payout is denominated in US dollars, the pound’s recent weakness means that UK shareholders might not see much of an increase.

Buy BHP?

Although I believe BHP’s US shale assets are a costly drag on its petroleum business, the overall quality of its mining and petroleum portfolio is high. On the financial side, BHP’s strong free cash flow performance means that shareholders shouldn’t have to worry about the affordability of the firm’s dividend payout.

In my view, BHP’s forecast P/E of 11.5 and prospective yield of 4.1% look attractive, and I rate the firm’s shares as a strong buy.

An income for life?

If you're interested in creating a portfolio with the potential to provide an income that stays ahead of inflation, then I believe that BHP shares should be on your short list.

However, before you hit the buy button, I'd strongly recommend you test BHP's dividend against the 'five golden rules' highlighted in "How To Create Dividends For Life" -- an important new report from the Motley Fool.

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> Roland does not own shares in BHP Billiton.