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One FTSE 100 stock yielding 12% I’d avoid and what I’d buy instead

High dividend yields are attractive to income investors for obvious reasons, but sometimes they are a symptom of investor apprehension. I think that shares of housebuilder Persimmon (LSE: PSN) fall into this latter category. A combination of slowing cash flow and changing fundamentals make it a little too risky for my tastes.

Too good to be true

Shares of the firm have been under significant pressure over the last 12 months, and are down 27% year-on-year. They are currently trading at an eye-popping dividend yield of 12%, and at a PE ratio of 6.7. While this may seem like a great deal, there are a number of reasons why investors are not too keen on the company. For one thing, it has suffered some severe reputational damage: its homes have been accused of being low-quality, it recently paid out a £75m bonus to its departing CEO and it faces significant industry headwinds from Brexit.

Moreover, a report by the National Audit Office recently found that the Help-to-Buy scheme has exposed the government to “significant market risk”, putting the future of the programme in question. Persimmon has been a major beneficiary of Help-to-Buy, in fact, it has sold proportionally more properties under the scheme than any other homebuilder.

Income investors should be asking two questions with this stock. Firstly, is the current dividend sustainable? Secondly, is there a significant risk of share value decline? Free cash generation declined between 2017 and 2018, from £806.3m to £686m, a fall of 15%. Cash on hand fell from £1.3bn to £1.05bn. This suggests that dividends could be cut in the near-to-mid-term future. If that happened, it would also affect the share price, causing negative total returns. For these reasons, I think Persimmon’s exceptionally high yield is too good to be true.

A turnaround with a strong dividend

On the other hand, insurance giant Aviva (LSE: AV) is an income stock that looks much more attractive. Shares of the £16bn company are down 21% year-on-year due to concerns over sluggish profit growth and underperformance relative to industry peers. However, the recent appointment of new chief executive Maurice Tulloch has investors believing again, with many cheering the plan to separate Aviva’s life insurance division from general insurance. Furthermore, he wants to cut costs by approximately £300m, which should go some way to alleviating the debt load and free up cash flow for further dividend payouts.

With a PE ratio of 10.5, it stacks up favourably against rivals, although a lot of that has to do with the poor results mentioned earlier. More importantly, shares of Aviva currently have a dividend yield of 7.3%, more than European-listed AXA at 5.9%, Legal & General Group at 6.1%, and Prudential at 3%. If the new management team can implement its cost-cutting measures, the dividend will begin to look even more attractive. For these reasons I think that Aviva could be a great income play at a cheap price.

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Stepan Lavrouk has no positions in any of the shares mentioned. 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.