Rolls-Royce (LSE:RR) joined the ranks of the FTSE 100 dividend shares this week. The company announced plans to distribute 30% of its underlying earnings after tax to shareholders from 2025.
The stock market’s taken the news very positively, sending the stock up 11%. So is this now one for passive income investors to consider buying?
What’s it worth?
The first question for investors is what will 30% of underlying earnings after tax look like? Rolls-Royce says this is the same as ‘underlying profit for the period’.
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During the first half of 2024, this came in at £737m. Doubling that (to get to the full year) hits £1.47bn, so 30% of that is around £442m.
Right now, Rolls-Royce has a market cap of just under £42bn. That means the implied dividend yield based on these calculations is slightly above 1%.
I suspect passive income investors aren’t going to find that hugely exciting. So the investment case is going to come down to the company’s ability to grow its earnings – and its dividend – from here.
Growth outlook
According to Rolls-Royce, the business is on track to hit its medium-term targets. Those include operating profits of between £2.5bn and £2.8bn a year.
During the first half of 2024, the company managed £1.1bn in operating income. And CEO Tufan Erginbilgiç has said the firm should manage roughly the same again in the next six months.
This means the business is actually quite close to its stated targets. But that probably doesn’t leave a huge amount of room for dividend growth going forward.
As a result, I’m dubious about the prospects for significant dividend growth going forward. And I think investors looking for passive income should probably think they have more attractive options.
Too late to buy?
It would have been a different story a year ago – the stock was 62% cheaper then than it is today. And that makes a difference to the likely dividend yield.
Investors who bought the stock last August would be looking at a prospective return of 1.6%. That doesn’t sound like much, but it’s 60% more than someone buying the stock today.
There are also important risks to consider. The most obvious of these right now is the cyclical nature of demand for air travel, as Ryanair has announced weakness in holiday bookings for this summer.
Rolls-Royce isn’t directly impacted by this, since its engines largely feature in long-haul aircraft. But I think investors would be unwise to rule out the possibility of a similar volatility in this space.
Dividends
A company announcing a dividend has traditionally been seen as a sign of weakness. It indicates management can’t find a way to use its excess cash to make the business grow.
With Rolls-Royce though, the situation’s different. The firm returning to paying dividends is evidence the business has fully recovered from the pandemic.
The trouble for investors is that the share price is also at a level that seems to reflect the anticipated growth. As a result, I think investors have better opportunities elsewhere.
