I have identified two of the best dividend yields on the FTSE 100 to help make me a passive income. Should I buy shares for my portfolio?
What is a dividend and a dividend yield?
The words ‘dividend’ and ‘dividend yield’ are bandied about a lot when it comes to investing. Allow me to explain them before I dive into how I plan on adding shares to my portfolio to make me a passive income.
A dividend is the distribution of some of a business’s earnings to its shareholders. The amount distributed is usually determined by the company’s board of directors who make executive decisions regarding the company and its direction.
These dividends are paid as a reward to shareholders for putting their money into the company. This money may have helped fund growth which has resulted in better financial performance, and therefore a dividend is returned to investors as a thank you if you like. Dividends are paid in the form of cash or additional shares.
So how do we determine a firm’s dividend yield? Lets say a company decides to pay a 10p dividend and its current share price is 100p per share. The yield equates to 10%. If the share price dropped to 50p per share, the yield would then be 20%.
Are there any risks involved?
There are risks involved with investing for dividends, as with all forms of investing.
Inflation is a big risk. Inflation effectively erodes the value of money. Higher inflation means means my investments have to work harder. For example, if prices rise by 5% each year due to inflation, my investments need to rise by the same percentage just to stay even.
It is worth noting that dividend investing and dividends are a great way to beat inflation. Generally speaking, dividends should increase faster than inflation, however, nothing is guaranteed. It is also worth remembering that higher inflation hurts businesses too! This is because the cost of production and overheads will rise. These higher costs may mean lower dividends later down the line.
What does a good dividend yield look like?
When looking for the best stocks to buy now for my portfolio to make a passive income, I always refer to the FTSE 100 first. This is an index of the 100 largest firms in the UK based on market capitalisation. The other FTSE indexes also have some good dividend stocks too, however. Personally, my first port of call is the FTSE 100.
The FTSE 100 dividend yield average is around 3%. I look for a minimum of 4%-6%. This is because I believe this level will protect me from inflation levels rising. In addition, I look to diversify my picks. This means I will look at different stocks in different industries to protect my money.
My first pick is mining giant Rio Tinto (LSE:RIO). The Anglo-Australian mining firm sells iron ore, aluminium, copper, lithium, and diamonds to over 2,000 firms worldwide. With over 60 mining operations spanning 35 countries and close to 50,000 employees, Rio is a mining mammoth. It also has a juicy dividend yield of over 10%!
In 2020, Rio Tinto’s profits rose by a hefty 22% to just short of $10bn. So far in 2021, underlying earnings are up 156% to $12.2bn. This is more than in all of 2020. Forecasts currently suggest a record dividend of $10.57 could be paid for 2021.
As I write, shares in Rio Tinto are trading for 4,402p. In the year-to-date, shares are down 19% from 5,470p. This does not worry me. In fact, I think the shares look dirt cheap right now as they trade at a forward price-to-earnings (P/E) ratio of close to 6!
Despite a cheap looking share price and a juicy dividend yield, I must note Rio Tinto has some credible threats. The commodities market is extremely volatile, especially in times of economic uncertainty like now. The prices of commodities have been bouncing around for a while now.
Rio Tinto makes a lot of money from selling iron ore. In fact, most of its revenue is derived from it. The price of iron ore has slumped in the past four months. Further price drops could affect profit and dividend payouts for the future. In addition, Rio has cut a dividend in the past, which means it wouldn’t be afraid to do it again. Analysts suggest this could happen if commodities prices continue to fall.
Overall, I do like Rio Tinto from a dividend investing point of view. I am well aware of the risks that come with mining stocks. My bullish stance comes from the current economic outlook. Economic reopening from the pandemic means demand for commodities will be strong, which should help firms like Rio. In turn, positive performance could mean a nice passive income for me. I would buy shares for my portfolio.
My second pick is smoking giant Imperial Brands (LSE:IMB). Imperial is a leading supplier of tobacco, cigarettes, and other smoking-related products. Some of its leading and most recognisable brands include Davidoff, Winston, and West.
Smoking and smoking firms have fallen foul of changing consumer habits and these consumers’ outlook on such firms. This shift in outlook has been more prominent in developed countries. In less developed countries, smoking is still rife and actually on the rise.
The rise of environmental, social, and governance (ESG) investors has also affected firms like Imperial badly. Despite this negativity, Imperial continues to yield a massive cash flow that allows it to pay huge dividends. As I write, Imperial’s dividend yield is close to 9%!
As I write, shares in Imperial Brands are trading for 1,564p. A year ago shares were trading for 1,219p, which is a healthy return of 28%. Imperial is another stock that looks cheap with a P/E ratio of close to 6 as well. Its value has been kept low due to the negative investor sentiment towards these types of products, as I mentioned earlier.
Imperial comes with risks as well. Obviously the investor sentiment issues have hampered it recently but this hasn’t affected performance too much or its dividend yield. It has cut dividends before in the pandemic period. There is always the risk this could happen again. Furthermore, lower demand in developed countries could hurt financials significantly in the future too.
The ethical considerations of tobacco do not concern me, as I am a smoker myself, although I smoke tobacco alternatives now. I think demand for Imperial’s products will remain strong for some time, especially from less developed markets, and that the dividend yield will remain high too. I would add shares to my portfolio.
Jabran Khan has no position in any shares mentioned. The Motley Fool UK has recommended Imperial Brands. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.