Does Royal Mail 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.

royal mailHowever, the FTSE 100 is up by 73% on its March 2009 low, and the wider market is no longer cheap. 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 Mail (LSE: RMG), to see if it might fit the bill.

The triple yield test

To gauge the affordability of a share for my portfolio, I like to look at three key yield figures –the dividend, earnings and free cash flow yield — and compare them to the returns available from alternative assets. I call this my triple-yield test:

Royal Mail Value
Current share price 565p
Dividend yield* 2.8%
Earnings yield* 5.7%
Free cash flow yield 4.9%
FTSE 100 average dividend yield 2.8%
FTSE 100 earnings yield 5.6%
Instant access cash savings rate 1.3%
UK 10yr govt bond yield 2.8%

*As Royal Mail hasn’t reported full-year results since it floated, and has had a lot of exceptional costs in recent years, I’ve based my figures on analysts’ consensus forecasts for the firm’s 2013/14 financial year, which ended on March 31.

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. Royal Mail’s 5.7% forecast earnings yield gives it a P/E rating of 17.5, roughly equal with the FTSE 100 average, but not particularly cheap.

The most likely reason for this somewhat pricey rating is that City analysts are forecasting earnings growth of around 30% this year — current consensus forecasts are pencilling earnings per share of 42p for 2014/15, which gives Royal Mail shares a forecast P/E of 13.5.

Royal Mail’s prospective dividend yield of 2.8% is equal with the FTSE 100 average, but promises much more: the postal group is expected to increase its payout to around 23p in 2014/15, giving a prospective yield of 4.1% at today’s share price.

A rich valuation?

In my view, Royal Mail’s current valuation is pricing in a fair amount of good news for the 2014/15 financial year. It’s quite possible that the Mail will deliver, but in my view there isn’t much near-term upside to the shares from their current price.

Indeed, I was quite concerned by Royal Mail’s latest interim statement, which reported flat parcel volumes over the key Christmas period — a big concern, given that the fast-growing parcel market is Royal Mail’s main hope for growth.

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Roland does not own shares in Royal Mail.