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Will Tesco plc become the best dividend stock in the FTSE 100?

It may seem rather strange to discuss dividends and Tesco (LSE: TSCO) in the same sentence. After all, the company did not pay a dividend in its most recent financial year. However, it seems to have significant scope to not only reintroduce one this year, but to grow it at a rapid rate. Therefore in time, it could become one of the top dividend stocks in the FTSE 100.

Changing business

Tesco is making huge changes to its business model. While a few years ago it was focused on becoming a conglomerate with assets in a wide range of countries, today it is returning to its roots as a UK-focused grocer. This should equate to greater efficiency and a focus on improving the company’s competitive advantage. It should also allow more capital to flow into developing its core offering.

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As well as improving its efficiency, the acquisitions and disposals programme put in place may lead to an improving balance sheet. The purchase of Booker could create synergies, while the sale of other assets is helping to reduce the company’s overall leverage. This may make higher dividends more likely in future, since lower debt may mean lower risk.

Growth potential

The changes being made by Tesco are due to result in significant earnings growth over the medium term. For example, in the current year it is expected to record a rise in its earnings of 40%, followed by additional growth of 30% next year. Not only could this act as a positive catalyst on the company’s share price, it may also lead to a rapidly-rising dividend.

In the current financial year, the company is due to reinstate a dividend so that it yields 1.8%. While unimpressive, it is forecast to raise dividends per share by 77% in the following year so that it yields 3.2%. However, even a 77% rise in dividends will leave Tesco with a forecast payout ratio of just 46%. This suggests that it could afford to pay out a higher proportion of profit as a dividend, which could mean dividend growth is higher than earnings growth over the medium term.

Competition

Of course, investors seeking a high yield today may wish to look elsewhere in the FTSE 100. One stock which offers a strong income outlook is diversified financial services business Old Mutual (LSE: OML). It currently yields 5.2% from a dividend which represents 46% of earnings. Therefore, there is also scope for the company to increase shareholder payouts at a faster pace than profit growth in future years.

In addition, Old Mutual is expected to grow its bottom line by 16% this year. This puts its shares on a price-to-earnings growth (PEG) ratio of 0.5, which mirrors that of Tesco. As such, both stocks seem to be worth buying at the present time. For more patient investors, Tesco could be the superior option, and in time it may become one of the FTSE 100’s very best income plays.

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Peter Stephens owns shares of Old Mutual and Tesco. The Motley Fool UK has recommended Booker. 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.

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