One of the risks of being an income investor is that you can be seduced by attractive yields, which are sometimes a symptom of a declining business or a falling share price.
Take BHP Billiton (LSE: BLT) (NYSE: BBL.US), for example. The firm’s 4.0% prospective yield is attractive, but, 4.0% is substantially less than the long-term average total return from UK equities, which is about 8%.
BHP’s share price has risen by 113% over the last five years. The question for investors is whether this commodities giant can continue to deliver long-term share price growth, or whether it is a ‘yield trap’?
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What will BHP Billiton’s total return be?
Looking ahead, I need to know the expected total return from BHP Billiton shares, so that I can compare them to my benchmark, a FTSE 100 tracker.
The dividend discount model is a technique that’s widely used to value dividend-paying shares. A variation of this model also allows you to calculate the expected rate of return on a dividend-paying share:
Total return = (Prospective dividend ÷ current share price) + expected dividend growth rate
Here’s how this formula looks for BHP Billiton:
(76.13 ÷ 1928) + 0.0516 = 0.911 x 100 = 9.1%
My model suggests that BHP shares could deliver a 9.1% annual return over the next few years, outperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker by a small margin.
Isn’t this too simple?
One limitation of this formula is that it doesn’t tell you whether a company can afford to keep paying and growing its dividend.
My preferred measure of dividend affordability is free cash flow — the cash that’s left after capital expenditure and tax costs.
Free cash flow is normally defined as operating cash flow – tax – capex.
BHP’s free cash flow was just over $1bn last year, meaning that it fell far short of the $6.2bn the company paid out to shareholders in dividends. However, the firm’s 30% operating margin and scaled-back capex plans should mean that this situation improves during the current year, and I’m not too concerned by last year’s cash shortfall.
It’s also worth noting that BHP’s dividend has risen continuously for 15 years, thanks to the miner’s policy of maintaining or increasing the dividend at every half-yearly payment.
