The Income Investor: better dividend prospects for FTSE 100 stock

The UK economy’s lacklustre performance may dissuade some income investors from buying domestically focused dividend stocks. Indeed, the UK economy failed to expand in the third quarter of last year and subsequently grew by a paltry 0.1% in the final quarter of 2024. And while the Bank of England estimates that UK GDP increased by 0.6% in the first quarter of 2025, the central bank forecasts that the economy’s growth rate will fall to just 0.1% in the second quarter of the year.

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Clearly, a slow-growing economy is unlikely to provide attractive operating conditions for businesses. This may mean they are unable to deliver higher profits, which could negatively impact on their ability to pay rising dividends. In some cases, it may even mean they struggle to afford their current level of shareholder payouts if, for example, they have a relatively high dividend payout ratio.

An upbeat economic outlook

While these circumstances may naturally prompt investors to look elsewhere for a worthwhile income, the outlook for UK-focused dividend stocks is surprisingly upbeat. Although inflation remains elevated at 2.6%, and is forecast to rise to 3.5% in the third quarter of this year according to the Bank of England, the central bank expects inflation to subsequently fall to its 2% target within the next two years. This should provide scope for further monetary policy easing that, when combined with the impact of previous interest rate cuts, has a positive effect on UK GDP growth once time lags have passed.

In fact, the Bank of England anticipates that the economy will expand by 1.3% in the 12 months to the second quarter of 2026. It then forecasts that UK GDP will increase by 1.5% over the next 12-month period before expanding by a further 1.9% in the following one-year period. As such, the current era of downbeat growth may not persist for much longer.

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An improving economic outlook bodes well for UK-focused firms. In particular, falling interest rates and a buoyant economy should boost wage growth. When combined with an inflation rate that is set to fall to 2% over the medium term, this should mean that consumers enjoy a continued increase in their spending power following consistent growth since April 2023.

Furthermore, savings rates now stand at 11.6%, which is their highest level since the pandemic. This should mean that consumers are in a relatively strong position to spend a significant proportion of their wage increases, especially since household spending growth has been subdued over recent quarters, thereby boosting the profitability and dividend prospects of UK-focused firms over the coming years.

Source: Refinitiv as at 14 May  2025. Bond yields are distribution yields of selected Royal London active bond funds (as at 31 March 2025), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 12 May. SONIA reflects the average of interest rates that banks pay to borrow sterling overnight from each other (9 May). *Data prior to May is based on 3-month GBP LIBOR. Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 14 May.

Sound fundamentals

Despite an upbeat long-term outlook for the domestic economy, as well as the operating conditions of those firms that rely upon it, many UK-focused companies trade on low valuations. This not only means they offer scope for capital growth, it also equates to relatively attractive dividend yields. When combined with the prospect of an improving economic outlook that boosts profitability and growth in shareholder payouts, UK-focused firms could provide a surprisingly attractive income investing outlook over the long run.

Additionally, many UK-focused firms have modest debt levels, a sound competitive position and well-covered dividends. This means they are well placed to overcome the UK economy’s present challenges, as well as ongoing geopolitical risks such as the global trade war and its potential impact on world GDP growth.

Certainly, the share prices of UK-focused firms could be subject to elevated volatility over the coming months amid the presence of what remains a highly fluid economic outlook. But their sound fundamentals, upbeat dividend growth prospects and attractive yields mean they should not necessarily be overlooked by long-term income investors.

Dividend growth prospects

Tesco (LSE:TSCO), for example, could prove to be a worthwhile income investing opportunity over the coming years. This is despite it having a dividend yield that is only roughly in line with that of the FTSE 100 index, currently at 3.6%. Furthermore, this is below the income return available elsewhere in the supermarket segment, with rival Sainsbury’s currently having a dividend yield of 4.9%.

Tesco, though, offers strong dividend growth potential to complement its current payout. In its latest financial year, for example, it raised dividends by 13.2%. This was largely a result of strong profit growth, with the firm’s earnings per share rising by 17%. Profitability was boosted by cost savings amounting to £510 million during the year, which contributed to a 33-basis point increase in the company’s operating profit margin so that it stood at 4.5%. It expects to generate a further £500 million of efficiencies in the current year, which should have a positive impact on profitability and the outlook for dividend growth.

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The company’s digital exposure may act as a further catalyst on its bottom line and capacity to raise shareholder payouts. It has a dominant position in the online grocery segment, with its market share rising by 173 basis points to 35.5% in its latest financial year. Given that the proportion of UK retail sales conducted online rose by 0.5 percentage points to 26.3% over the past year, and is up 14.6 percentage points over the past decade, the company is well placed to capitalise on current consumer trends.

A competitive advantage

Despite their double-digit rise, Tesco’s dividends were still covered twice by profits last year. This suggests that even if operating conditions worsen in the short run amid a challenging UK economic environment, dividend cuts are unlikely to be required. And with the company having a sound financial position, as evidenced by a net interest coverage ratio of around six, it is well placed to overcome difficult operating conditions in the short run.

Indeed, the supermarket sector is currently undergoing a period of intense competition as incumbents such as Asda invest heavily in pricing in response to a loss of market share. Tesco’s loyal customer base, evidenced by the fact that over 23 million UK households currently have a Clubcard, could be helpful in sustaining the firm’s strong financial performance and dividend growth in such an environment. It may mean that the company’s customers are less likely to switch to rivals, which could allow it to generate relatively high margins and further improve its competitive position.

Income investing appeal

Since first being discussed in this column during July 2023, Tesco’s share price has risen by around 53%. This represents a 35-percentage point outperformance of the FTSE 100 index. Despite this, the stock continues to trade on a relatively modest market valuation. For example, it has a price/earnings (PE) ratio of 13.8. This suggests that it offers a wide margin of safety amid an uncertain near-term outlook for the economy and the supermarket segment, as well as scope for further capital growth to complement its attractive income prospects over the coming years.

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Indeed, Tesco’s income investing potential remains relatively high. Although its aforementioned share price rise means it now has a lower yield than when it was first discussed in this column, with its income return standing 80 basis points higher at 4.4% in July 2023, the company’s dividend growth potential means its income return is likely to be relatively appealing over the coming years.

This is especially the case given an upbeat outlook for the UK economy. When combined with the firm’s healthy dividend cover and its potential to generate higher profits amid cost savings, as well as a strong financial position and competitive advantage, it appears to offer a worthwhile income investing opportunity.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.