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Does Royal Dutch Shell Plc Pass My Triple Yield Test?

royal dutch shell

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 Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.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:

Royal Dutch Shell Value
Current share price 2,264p
Dividend yield 4.9%
Earnings yield 8.4%
Free cash flow yield 0.2%
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. Shell’s earnings yield of 8.4% highlights the firm’s low valuation — it currently trades on a P/E multiple of less than 12 times 2013 earnings.

Shell’s 4.9% dividend yield is also attractive, but the firm’s spending has run out of control in recent years, a problem highlighted by last year’s free cash flow yield of just 0.2%.

This low figure is the result of Shell’s runaway spending in 2013: Shell generated operating cash flow of $40.4bn last year, but $40.1bn of this was swallowed up by capital expenditure commitments.

This left almost no free cash flow to fund the firm’s $5bn share buyback and $7.2bn of cash dividend payments — expenditure that was funded using new debt and Shell’s cash reserves, which fell from $18.6bn to $9.7bn last year.

Change starts at the top

Institutional investors have become increasingly unhappy with Shell’s spendthrift ways, and the firm’s new chief executive, Ben van Beurden, has indicated that things will change.

Since taking charge four weeks ago, Mr van Beurden has already announced disposals worth $2.1bn, and the firm said yesterday that it is planning up to $15bn of asset sales over the next two years, while also applying tougher criteria to new investment decisions.

I’m confident in Shell’s turnaround plans, and believe that like the big miners, Shell will find a way to cut costs and boost shareholder returns. Based on this, I rate Shell as a strong buy for 2014.

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> Roland owns shares in Royal Dutch Shell.