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Is this the best income stock in the world?

Image: Direct Line. Fair Use.

Direct Line (LSE: DLG) has released a positive trading update for the first nine months of 2016. It shows that the company is on track to meet its guidance and that its strategy is progressing well. Alongside a high yield, does this make it the best income stock in the world?

Direct Line’s Motor and Home own-brands in-force policies were up 4.3% in the first nine months of the year, with the company enjoying strong customer retention. It also continues to experience growth in Green Flag direct and Direct Line for Business. Alongside this, Direct Line’s gross written premiums for ongoing operations were 4.2% higher than in the previous year, with its investment income yield of 2.5% being in line with full-year guidance.

However, Direct Line’s total costs are up £16.1m versus the first nine months of 2015 at £669.5m. This is partly because the company has had to absorb £24m of Flood Re costs in the second quarter of the year.

Encouragingly for the company’s investors, third quarter costs were 3.3% lower than in the same quarter of the previous year. Furthermore, full-year business-as-usual costs are expected to be no higher than they were in the previous year. And with Direct Line’s combined operating ratio set to be towards the lower end of the 93%-95% operating range, its short-to-medium term outlook is positive.

In terms of its dividend appeal, Direct Line’s yield of 7.5% is among the highest in the FTSE 100. However, its high rewards aren’t risk-free. Direct Line’s dividends are only due to be covered 1.1 times by profit next year. This means that the company doesn’t have significant scope to raise shareholder payouts at a rapid rate – especially when its bottom line lacks stability and consistency.

For example, in the next financial year Direct Line’s earnings are due to fall by 4%. In addition, the insurance industry is less stable than other sectors such as utilities and tobacco. Therefore, higher yields should be demanded by investors since a higher risk should mean a higher potential return.

Let’s look at the competition

Direct Line’s dividend appeal remains high when compared to other insurance sector companies. For example, Admiral (LSE: ADM) yields 6.5% from a dividend that’s not due to be covered by profit in the current year.

Of course, Admiral and Direct Line’s shareholder payouts include special dividends that can be turned on or off depending on their financial performance and outlook. Therefore, this provides them with greater financial flexibility in future, although it also means that their dividend yields may not remain so high over the medium-to-long term.

Where Direct Line has greater appeal than Admiral is with regard to its valuation. Direct Line trades on a price-to-earnings (P/E) ratio of only 11.5, while Admiral’s P/E ratio is 17.1. Although both stocks have significant income appeal, Direct Line offers greater rerating potential as well as a higher yield. This makes it the better income option. But due to its high payout ratio and lack of stability versus dividend stocks in other sectors, the answer to my question is: no, it’s not the best income stock in the world.

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Peter Stephens owns shares of Admiral Group and Direct Line Insurance. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.