The Aviva (LSE: AV) share price now offers a dividend yield of 9%. This makes the insurance giant one of three highest yielding stocks in the FTSE 100, by my calculations.
That 9% is a very high dividend yield. Normally, I think you’d be right to worry about the risk of a cut. But in this case I think the payout could be safe, as I’ll explain.
The most common way to test whether a dividend is affordable is to compare it to a company’s earnings per share. This is known as dividend cover.
Aviva scores well here. Last week the insurer reported 2019 earnings of 63.8p per share. The total dividend for the year was 30.9p per share, so giving dividend cover of 2.1 times. That’s generally a very comfortable level of payout.
Look at the cash
However, ultimately dividends are paid from a company’s cash flow. Accounting profits (earnings) don’t always match the surplus cash generated by a company each year.
So if you really want to see how safe a dividend is, I think the acid test is to see whether it’s covered by free cash flow. This is the surplus cash generated by a business each year, after capital expenditure, tax and interest payments.
My sums show that the Aviva dividend costs about £1.2bn each year. This payout is supported by the surplus cash generated by the group’s operating companies, which totalled £2.6bn last year.
These numbers suggest to me that as in previous years, Aviva’s payout looks comfortably supported by the group’s cash generation.
In my opinion, Aviva’s dividend looks very safe.
What’s the catch?
If it looks too good to be true, it probably isn’t true. These are wise words to live by, in my experience. So if Aviva’s 9% dividend yield is safe, what’s the catch?
Aviva’s shares have been cheap for years because the group has struggled to deliver much growth. This remains a concern. Sales of general insurance (such as motor and home) rose by just 2% last year.
A related problem is that Aviva’s profit margins are pretty average, in my view. The group’s underlying return on equity was 8.1% last year, which is not spectacular. Chief executive Maurice Tulloch is targeting a figure of 12% by 2022, but even this is still fairly modest.
In my view, Aviva’s strength and investment appeal lies in its large size and strong cash generation. Last week’s results looked pretty solid to me, but there’s a reason for the stock’s cheap rating — this business is unlikely to expand very much further.
If you want to invest in a business that will grow ahead of the wider market, I think there are better options elsewhere.
But if you’re looking for a generous and reliable income, I don’t think Aviva’s low growth rate is a problem. Indeed, I think this insurance firm is one of the best pure income buys in the FTSE 100 today.
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Roland Head owns shares of Aviva. 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.