The Income Investor: a FTSE 100 share with dividend potential

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The FTSE 100 index’s 17% rise over the past year means it now yields just 3%. With easy-access cash savings accounts offering up to a 5% return, and government bond yields having recently spiked (10-year gilts currently yield around 5.2%), many income investors may wonder whether the UK’s large-cap index has lost its appeal.

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Furthermore, a global trade war and conflict in the Middle East and Europe may weigh on the world’s GDP growth rate in the short run. This could prompt challenging trading conditions even for fundamentally sound FTSE 100 firms that act as a drag on their profitability, limit their scope to raise dividends and harm their share price performance in the coming months.

In addition, persistently high inflation that is expected to rise by 50 basis points to 3.4% by the end of the year, could prompt the Bank of England to raise interest rates. Alongside similar high inflationary environments in other developed economies such as the US and the eurozone, this could further harm the operating environment of FTSE 100 firms and weigh on dividend growth rates.

A long-term holder’s perspective

While the FTSE 100 index’s relative lack of income appeal may naturally prompt some investors to pivot to other mainstream assets such as bonds and cash, its long-term outlook is far more upbeat.

Crucially, inflation is forecast to fall next year, down to just 2.2% by the end of 2027. This should provide the Bank of England with scope to implement interest rate cuts, particularly if the rate of GDP growth is disappointing. Monetary policy easing is likely to catalyse the FTSE 100 index’s dividend growth rate as lower borrowing costs bolster the economy’s performance.

As a result of similar forecasts for falling inflation in the US and the eurozone, individuals who purchase a basket of UK large-cap shares are likely to ultimately receive a far higher level of income return on their original investment than the index’s present 3% yield amid dividend growth.

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Conversely, falling interest rates would almost certainly equate to lower returns on cash savings accounts. And with coupons paid on gilts being fixed, any difference in today’s income return between government bonds and the FTSE 100 is likely to narrow over the long term as dividend growth potentially negates at least part of it.

Source: Refinitiv as at 4 September 2026. Bond yields are distribution yields of selected Royal London active bond funds (as at 2 September on Trustnet), except the global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 2 September. SONIA reflects the average of interest rates that banks pay to borrow sterling overnight from each other (1 September). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 4 September and which exclude bonuses.

Portfolio considerations

Clearly, some FTSE 100 members are likely to offer superior dividend growth rates than the wider index. Unearthing them, while also demanding a relatively attractive yield, could therefore be key to generating a more appealing income return than the wider index and other mainstream asset classes.

Such firms may, for example, have relatively high dividend cover that allows them to raise shareholder payouts at a faster pace than profit growth. They may also have stronger earnings growth prospects than the wider index and modest debt levels that allow for excess capital to be distributed to shareholders rather than to reduce borrowings.

These stocks may also operate in industries that are set to be major beneficiaries of falling inflation and interest rate cuts, such as consumer-focused sectors. Meanwhile, their relative cyclicality could equate to a financial performance boosted by an upbeat long-term economic outlook to a greater extent than the wider index.

Indeed, over the long run, a surprisingly large number of FTSE 100 members could deliver attractive income returns as they benefit from improved operating conditions. When combined with their inherent capital growth potential, which can sometimes be overlooked by yield-focused investors, the UK’s large-cap index continues to offer relative appeal on a long-term view.

Dividend growth potential

FTSE 100 constituent Tesco (LSE:TSCO) currently yields 3.1%. Although this is only 10 basis points higher than the index’s yield, the retailer has scope to raise dividends at a relatively brisk pace.

Even though it increased shareholder payouts by an inflation-beating 5.8% on a per share basis in its latest financial year, they were still covered twice by earnings per share (EPS). Given that the company aims to have a dividend payout ratio of 50%, it could realistically increase shareholder payments at the same rate as profit growth over the long run.

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Currently, the company is forecast to produce an 8% annualised rise in EPS over the next two financial years. A similar rate of dividend growth, if delivered, is likely to not only be well in excess of inflation, but also greater than the growth rate of shareholder payouts among a basket of FTSE 100 index stocks.

Furthermore, if maintained over a longer time frame, a high-single-digit dividend growth rate would be likely to adequately compensate investors for the stock’s relatively humdrum yield compared with income returns currently offered by other mainstream assets.

An uncertain near-term outlook

Clearly, UK-focused retailers such as Tesco face an uncertain near-term future. If, as expected, inflation rises and this leads to interest rate increases, the outlook for consumers could deteriorate as additional pressure is put on their spending power after a lengthy period of cost-of-living challenges. This could weigh on the retailer’s near-term growth prospects and lead to elevated share price volatility over the coming months.

The company, though, has the financial means to overcome potential short-term difficulties. Notably, its net interest costs were covered nearly six times by operating profits in its latest financial year.

Furthermore, it has a strong competitive position, as evidenced by an improving net promoter score in its latest quarterly trading update, while membership of its Clubcard loyalty scheme now extends to 24 million households. This should mean its customers are less likely to switch to potentially cheaper competitors, even if cost-of-living challenges persist.

Long-term potential

In the longer term, of course, Tesco is set to experience improved operating conditions. Inflation is forecast to fall next year so it stands just 20 basis points above the Bank of England’s 2% target. This could mean that rate cuts move onto the central bank’s agenda much sooner than many investors currently anticipate.

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The combination of lower inflation and looser monetary policy should boost consumer spending power. In turn, this may shift the focus of shoppers away from prices of products and towards other factors such as convenience, product quality and service as they gradually become less price conscious.

When combined with its strong competitive position, this may allow Tesco to raise prices to increase profit margins. Over time, this could catalyse its bottom line and provide greater scope for higher dividends.

Investment potential

Alongside its income investing potential, Tesco offers attractive capital return prospects. Its 8% share price rise over the past year, which equates to a nine-percentage point underperformance of the FTSE 100 index, means it trades on a forward earnings multiple of 15.1. This is lower than the UK large-cap index’s price/earnings (PE) multiple of 18 and suggests scope for an upward rerating.

While capital gains may not be a priority for income investors, an attractive outlook in this respect undoubtedly enhances the stock’s overall appeal. When combined with its sound fundamentals and potential to deliver brisk dividend growth over the coming years, the retailer could offer a favourable risk/reward opportunity on a long-term view.

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