Are these the best dividend stocks in the FTSE 100?

Dividend investors in the UK are in a privileged position as the FTSE 100 index is home to many high yielding dividend stocks. However just because a stock has a high yield doesn’t automatically mean you should buy it. It’s important to consider the sustainability of the dividend and today I look at two popular FTSE 100 dividend plays and examine whether their yields are sustainable.

Legal & General Group

Legal & General Group’s (LSE: LGEN) shares have fallen almost 17% this year and investors buying now will be hoping to get their hands on a formidable 6% dividend yield.

A 6% yield is considerably greater than the FTSE 100’s average yield of around 4%, and often when a stock has a dividend yield that’s significantly above the market average, it’s an indication that the dividend is about to be cut. If a yield seems too good to be true, caution is warranted. Just look at what happened to Tesco shares when its dividend was cut.  

So is Legal & General’s dividend sustainable or is the insurer a dividend trap?

One tool in assessing dividend sustainability is the dividend coverage ratio. This is the ratio of the company’s earnings to the dividend paid to shareholders. A ratio of under 1.5 is seen as risky while a ratio of over 2 is seen as healthy.

In Legal & General’s case, FY2015 adjusted earnings per share were 18.58p and the dividend paid out was 13.4p. That’s a dividend coverage ratio of 1.39, a level a little on the low side, but not a huge cause for concern.

The insurer’s earnings have risen at a steady rate over the last five years and despite ‘Solvency II’ regulation concerns, City analysts forecast earnings of 21p per share for the next two years. The company said in July that its strategy was resilient and unlikely to be affected by Brexit and for this reason, I think it’s unlikely we’ll see a dividend cut from Legal & General. I believe the 6% yield on offer is one of the better yields in the FTSE100.

Royal Dutch Shell

In contrast, I believe there’s a much higher chance of a dividend cut at Royal Dutch Shell (LSE: RDSB).

There’s no doubt the oil major is an income favourite for UK investors, having not cut its dividend since World War II. And with the weak pound, Shell’s US dollar denominated dividends represent a 7.5% yield in sterling terms.

But looking at the dividend coverage ratio, there are some questions over sustainability. Shell paid dividends of $1.88 per share in FY2015, yet adjusted earning per share were just 31 cents. That’s a dividend coverage ratio of just 0.16, which should definitely be ringing alarm bells.

The issue with Shell is that it has no control over the oil price and therefore no control over earnings. Analysts generally agree that the oil majors need an oil price of at least $60 to $70 to maintain their dividends and right now the price is under $50.

Shell is currently undergoing a $30bn asset disposal programme to pay down debt and help fund the dividend, but unless the oil price rises, the company is going to struggle to maintain its dividend. Shell might have one of the highest FTSE 100 yields at present, but I say proceed with caution.

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Edward Sheldon owns shares in Legal & General Group and Royal Dutch Shell. The Motley Fool UK has recommended Royal Dutch Shell B. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.