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Is GlaxoSmithKline plc A Better Income Buy Than Vodafone Group plc?

Despite facing various challenges, GlaxoSmithKline (LSE: GSK) and Vodafone Group (LSE: VOD) remain two of the most popular dividend stocks in the FTSE 100.

Indeed, legendary fund manager Neil Woodford recently increased his firm’s shareholding in Glaxo, saying that “fundamentals have played no part” in recent short-term weakness.

I own shares in both companies and in this article I’ll take a closer look at the numbers and at the issues facing each firm.

Will history repeat?

One way to get an idea of whether a company is cheap only because of short-term problems is to average out past years’ earnings, and compare them to the current share price.

The most popular way of doing this is divide the current share price by the average of the last ten years’ earnings per share. This ratio is known as the PE10:

Company

PE10

GlaxoSmithKline

15.5

Vodafone Group

7.6

GlaxoSmithKline

Glaxo’s PE10 of 15.5 is broadly in-line with the firm’s current forecast P/E of 17.5, which is expected to fall to 15.5 in 2016.

The firm currently faces a short-term challenge to replace the profits from patent-expired products such as Advair. However, I think that the combined impact of new products and the assets gained through this year’s deal with Novartis are likely to solve this problem over the next 3-5 years.

Glaxo is also very profitable. The group’s operating margin has averaged 22% over the last five years, and it generates consistently high levels of free cash flow.

On this basis, I think Glaxo shares are cheap enough to be a buy, and like Neil Woodford, I recently added more to my own portfolio.

Vodafone

Vodafone is more interesting. The £59bn profit generated when Vodafone sold its share in Verizon Wireless for $130 billion in 2013/14 means that the shares boast a PE10 of just 7.6. However, if you exclude this gain, the shares trade on a pricey PE10 of 22.

I think it’s reasonable to include the Verizon Wireless profit. However, I don’t think Vodafone is as cheap as its PE10 of 7.6 suggests. The firm still needs to prove it can replace the earning power it lost by selling Verizon Wireless.

With this goal in mind, Vodafone is using some of the cash from the Verizon Wireless sale to upgrade its network. Project Spring is expected to cost £19bn and take two years. Unfortunately, this massive surge in capital expenditure, along with the European downturn, has crushed Vodafone’s profits.

However, despite forecast earnings per share of just 5p this year and 5.8p next year, Vodafone has chosen to maintain its 11p dividend, giving a prospective yield of about 5.5%.

Vodafone’s management believes earnings will rise to provide adequate dividend cover once Project Spring is completed. They could be right. The firm’s latest trading update also suggests market conditions are improving in Europe.

The best income buy?

Both Vodafone and GlaxoSmithKline are huge, complex businesses which invest and plan for the long term. I suspect both will do well over the next 5-10 years.

However, I do have some reservations about how successful Vodafone will be at rebuilding its earnings without a major acquisition. I’m more comfortable with Glaxo, which has already laid out a plan to replace its lost profits.

On this basis, my pick today would be GlaxoSmithKline.

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Roland Head owns shares of GlaxoSmithKline and Vodafone Group. The Motley Fool UK has recommended GlaxoSmithKline. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.