Income Investor: two FTSE 100 stocks tick dividend investing boxes

Many income investors focus almost exclusively on dividend yields when deciding which stocks to buy. While this is understandable, since they typically require a minimum level of income from their portfolio, there is far more to contemplate when determining which companies are worthwhile income investments.

• Our Services: SIPP Account | Stocks & Shares ISA | See all Investment Accounts

For example, high-yielding stocks are often lowly priced due to them having uncertain future prospects that may ultimately prompt a reduction in dividends. Meanwhile, lower-yielding shares with relatively high market valuations may still be worth buying due to their potential to deliver rapidly rising dividends based on an upbeat earnings outlook.

A simple checklist

Using a simple checklist makes the process of deciding which income stocks to buy far easier. Although any checklist is highly subjective, in terms of what it covers and the requirements to successfully “tick” a particular part of it, the process of considering each facet of a company’s income potential, rather than just focusing on its yield, is likely to be highly beneficial to long-term investors.

For example, a sound starting point for any income investing checklist is dividend affordability. Indeed, there is little point in buying any stock that is unlikely to be able to at least maintain its current level of shareholder payouts. Dividend cover is calculated by dividing earnings per share by dividends per share. A figure of one means shareholder payouts were fully covered by profits, with a higher reading equating to a lower risk of dividend cuts and a greater prospect of dividend growth matching, or even exceeding, earnings growth in future.

• Sign up to our free newsletter for investment ideas, latest news and award-winning analysis
• Insider: activity at Aviva, Lloyds Bank, Indivior and Galliford Try

Similarly, ensuring that a company is financially sound before buying its shares can mean a lower chance of dividend cuts in future. For instance, a business with large debts may struggle to grow dividends if their borrowings are due to refinance at a higher interest rate in the current era of restrictive monetary policy They may also fail to pay a higher dividend during a period of weak economic growth if a large proportion of their profits are used to service existing debt.

Therefore, checking that a firm’s debt-to-equity ratio, which is calculated by dividing total debt by net assets, is not excessive could equate to a more reliable income in future. Likewise, ensuring that net interest cover, calculated by dividing operating profits by net interest payments, is sufficiently high may mean more robust shareholder payouts over the coming years.

Dividend growth potential

While every company’s future rate of dividend growth is a known unknown, investors can gauge the likelihood of higher shareholder payouts based on a company’s earnings prospects. For example, a business that has a clear competitive advantage, opportunities to expand into new regions or markets, and is highly dependent on the economy’s performance could offer strong dividend growth potential ahead of impending interest rate cuts and an improving economic outlook.

However, rapid earnings growth may not necessarily be passed on to investors in the form of higher dividends. Directors of growth companies may, for instance, determine that reinvesting profits, rather than paying them to shareholders, represents the most efficient use of capital due to the high returns on offer.

Therefore, investors should not only include a consideration of earnings growth potential in their checklist, but should contemplate the maturity of a company before purchasing it. Income investors seeking a relatively reliable rate of income growth may, for example, be better off purchasing a more mature business that provides relatively modest earnings growth potential. It could offer a higher chance of any rise in profits being passed on to shareholders in the form of a higher dividend.

Clearly, companies with a solid track record of raising dividends may be more likely to offer growing shareholder payouts in future vis-à-vis firms that have a more chequered income past. But history, of course, is never perfectly repeated in future. Therefore, investors who include the track record of a company’s dividends in their checklist should not overestimate its importance.

Source: Refinitiv as at 11 March 2024. Bond yields are distribution yields of selected Royal London active bond funds (31 January 2024), except global infrastructure bond which is 12-month trailing yield for iShares Global Infras ETF USD Dist as at 8 March. LIBOR is interest rate that banks lend money to one another (3 month GBP LIBOR as at 8 March). Best accounts by moneyfactscompare.co.uk refer to Annual Equivalent Rate (AER) as at 11 March.

An improving dividend outlook

Applying the aforementioned checklist to FTSE 100 consumer goods companies Unilever (LSE:ULVR) and Reckitt Benckiser Group (LSE:RKT) highlights their long-term income investing appeal.

Unilever’s dividend, for example, was covered over 1.5 times by profits in its most recent financial year. This suggests it is highly affordable, with the firm’s solid financial position further reducing the prospect of dividends being cut in future. Net interest costs, for instance, were covered 20 times by operating profits in the 2023 financial year.

• The four FTSE 100 companies paying £6bn of dividends in March
• Six ways to recession-proof your finances

Clearly, the company is experiencing an uncertain period as higher interest rates and rampant inflation negatively affect consumer demand across several of its key markets. However, it was still able to deliver underlying sales growth of 7% and a rise in underlying earnings per share of 11% at constant currency in its latest full year. Its financial performance is highly likely to improve as an end to the current era of restrictive monetary policy and above-target inflation prompts higher demand for discretionary items. This could allow it to raise dividends after they were held at the same level in 2023 as in the previous year.

The firm’s refreshed management team is aiming to improve the competitiveness of its products, with investment being focused on the company’s biggest brands. It is also seeking to grow profit margins, with them rising by 60 basis points to 16.7% at the operating level in the 2023 financial year. While this revised strategy will inevitably require significant reinvestment in the near term, ultimately it is likely to create a more profitable, fast-growing business that can raise dividends at a brisk pace in the coming years.

With a dividend yield of 3.8%, Unilever is by no means one of the FTSE 100’s highest-yielding stocks. However, as a mature company with a diverse range of products, a solid financial position and clear dividend growth potential, it is a relatively attractive income investing opportunity for the long term.

A turnaround opportunity

Reckitt Benckiser’s recently released full-year results were poorly received by investors. The company’s share price declined by 13% on the day of their release, with its financial performance failing to meet analyst expectations. Indeed, earnings declined by 5.4% versus the prior year as the firm’s nutrition segment recorded a sales decline of 4% due largely to a tough prior year comparator.

Despite this, and an annual increase in dividends per share of 5%, shareholder payouts were amply covered 1.7 times by profits. When combined with the company’s solid financial position, as evidenced by a net gearing ratio of 84% and net interest cover of 19, they are highly affordable at current levels. Moreover, the company’s wide range of brands and the relatively high level of customer loyalty they command, mean its financial performance is likely to be relatively robust over the long run.

In terms of dividend growth potential, Reckitt Benckiser’s financial performance is set to benefit from an improved operating environment as the cost-of-living crisis abates. It is also implementing a revised strategy under a new management team, with it aiming to improve profitability via a reduction in fixed costs. While it is investing heavily in product innovation, which is centred on releasing new products under existing brands, it expects to deliver “sustainable” dividend growth over the coming years.

Income-seeking investors should not be dissuaded from purchasing the stock based on its relatively modest yield of 3.9%. The company’s capacity to generate improved financial performance, a solid balance sheet and well-covered dividend mean it is a worthwhile income investment for the long run.

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