I’m targeting a 5.5% dividend yield from Royal Bank of Scotland Group plc

The release of half-year results from RBS (LSE: RBS) on Friday could signal the start of a brighter period for the bank’s shareholders. It has swung from loss to profit, and is making progress with its goals for the current year. While it may still have some way to go before it returns to full financial health, dividend growth is now on the horizon. It could even yield as much as 5.5% over the medium term.

Improving performance

Having reported an attributable loss of over £2bn in the first half of 2016, its swing to a £939m profit in H1 2017 is an impressive result. It has been able to achieve this despite a highly uncertain outlook for the UK economy, which provides evidence that its strategy is working well.

Key to its success has been income growth and cost reductions. It has been able to increase core adjusted income by 8.6%, while core adjusted operating expenses have fallen 4.1%. This has resulted in a far healthier cost-to-income ratio of 54.3% versus 61.6% in the previous period. Operating JAWS (or the rate at which income growth exceeds cost changes) was 12.7%, and there seems to be further scope for improvements in its profitability.

Dividend potential

RBS is expected to recommence dividend payments in the current year. Although they are likely to amount to just 0.47p per share, which gives a prospective yield of only 0.2%. But the bank is due to increase shareholder payouts at a rapid rate over the medium term.

Next year, for example, dividends are expected to amount to 9.2p per share. This puts the stock on a prospective yield of 3.5%. However, even with such rapid growth in dividends, the bank’s payout ratio would only amount to 39% using forecasts for earnings.

Therefore, assuming a relatively affordable 60% payout ratio over the long run, it could mean that RBS has a dividend yield of 5.5% at today’s share price. Furthermore, this assumes no growth in earnings, which judging by today’s positive results is unlikely to be the case. As such, RBS could quickly become a must-have dividend stock in future years.

Growth prospects

Also offering upbeat dividend growth prospects at the present time is financial services sector peer Prudential (LSE: PRU) (PRU.L). It may only yield 2.6% right now, but it pays out just 33% of its profit as a dividend. This suggests a much higher dividend could be affordable in future, which may lead to the stock becoming a more popular income share.

In terms of outlook, Prudential’s diverse business model means it has an attractive mix of growth and defensive characteristics. It is forecast to increase its bottom line by 8% in the current year. And with it trading on a price-to-earnings (P/E) ratio of 12.9, it seems to be relatively cheap. Therefore, with a rapidly growing Asian economy forming a key part of its business, now could be a good time to buy it.

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Peter Stephens owns shares of Prudential and Royal Bank of Scotland Group. The Motley Fool UK has no position in any of the shares mentioned. 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.