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 J Sainsbury (LSE: SBRY) (NASDAQOTH: JSAIY.US), for example. The firm’s 4.1% prospective yield is attractive, but, 4.1% is substantially less than the long-term average total return from UK equities, which is about 8%.
Sainsbury’s share price has risen by 23% this year alone, comfortably outpacing the FTSE 100’s 10% gain. Can Sainsbury continue to outperform, or will its share price slip back, erasing the returns provided by its dividend?
What will Sainsbury’s total return be?
Total return is the gain provided by share price growth and dividends combined. To evaluate a possible investment in Sainsbury, I need to know the supermarket’s expected total return, so that I can compare it 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 Sainsbury:
(17.3 ÷ 423) + 0.035 = 0.075 x 100 = 7.5%
My model suggests that Sainsbury shares could deliver a 7.5% annual return over the next few years, narrowly underperforming the long-term average total return of 8% per year I’d expect from a FTSE 100 tracker.
To me, this suggests that Sainsbury’s shares are already fully valued, and that now may not be the best time to buy into this British firm.
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 operating cash flow that’s left after capital expenditure, tax costs and interest payments.
Free cash flow = operating cash flow – tax – capital expenditure – net interest
Sainsbury generated free cash flow of £119m last year, falling short of the £308m it needed to cover its dividend payments. The same story applied in the previous year, as the firm invested more than £1bn in its business in both years — stretching its cash flow very thin.
