'Total yield': A new way to hunt down a decent income

With interest rates so low, most of us would like to get a decent income from our stocks. But it's a mistake to just look at dividend yield, Chris Brightman of Research Affiliates tells Fortune. Instead, you should consider the total yield'. So what is it, and why does it matter?

The trouble with dividend yields

The dividend yield on a stock is simply the annual dividend expressed as a percentage of the share price (take the last 12 months if you want a historic' yield, or the analysts' forecasts for the next 12 months for a prospective' yield). So if the forecast dividend is 10p per share and the share price is £2, the prospective yield is (10p/£2) x 100%, or 5%.

From an income investors' point of view, the higher the better, subject to a few safety checks on a firm's ability to keep paying dividends at that level. The problem now, however, is that rising share prices have driven yields lower. In turn, investors desperately hunting for an inflation-beating income have been taking ever more risks to get it.

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A better approach, and one that won't expose you to as much risk, is to focus on total yield', says Brightman. This factors in both dividend yield and share buybacks.

What are buybacks?

A company that has spare cash and wants to boost its earnings per share (EPS) can use a share buyback. The firm offers to pay existing shareholders a fixed price for their shares. In doing so, it gets rid of the excess cash, gives a bonus cash return to those shareholders, and even improves the firm's performance (on paper at least).

Imagine a firm has 100 million shares in issue, and makes a profit of £10m. EPS is £10m/100m, or 10p. Say the firm buys back ten million shares. If earnings don't change, EPS is now £10m/90m, or 11.1p.

Understandably, firms that engage in buybacks are often criticised for this sleight of hand and for the fact that buybacks usually target selected shareholders the firm could pay out any spare cash as a dividend to all shareholders instead. Yet, says Brightman, in today's environment, these firms are worth targeting.

Looking for a total return

Brightman, notes Fortune's Shawn Tully, believes "that the overall market will reap puny rewards for the foreseeable future". In the past, investors have expected to get around 9% a year (including inflation). They'll have to lower their expectations, says Brightman.

The current dividend yield on the S&P 500 is 2%, half its historic average. He reckons EPS, meanwhile, will grow by just 1.5% a year, after inflation of around 2.5% a year. That gives an expected return of around 6%. So investors need to take any boost they can get their hands on. And one way to do it, says Brightman, is to target firms with a total yield of 8% or more.

There are four key components. The first is an above-average dividend yield (3% or higher, in the case of the S&P 500). Next, look for a firm that's expected to buy more than 2% of its outstanding shares each year. The logic here is that (assuming profits remain steady) EPS, and therefore the share price, should rise by about 2% a year too.

Brightman then looks for firms that are expected to grow their earnings by inflation plus 0.5% a year (3% in total). Those elements added together give you your 8% (3% dividend yield, 2% share buybacks, and earnings growth of 3%).

The final test is to check for decent free cash flow (the cash generated by a firm's operations, less the cost of capital expenditure required to maintain those cash flows). That increases the odds that a company will be able to maintain its dividend and buyback programmes.

What to buy

Among others, Brightman's screen throws up two stocks we like: pharmaceutical giant Pfizer (NYSE: PFE) with a 3.6% yield and 4% from buybacks; and medical equipment maker Medtronic (NYSE: MDT), which offers a 2.3% yield plus 3.7% from buybacks.

Alternatively, you could consider the PowerShares Buyback Achievers Portfolio ETF (NYSE: PKW). It's posted an annualised five-year return of 8.5% compared to 4.8% for the S&P 500. It targets firms that have repurchased at least 5% of their outstanding shares over the previous 12 months.