As the FTSE 100 climbs in December, here’s why I think it’s still cheap

The FTSE 100 is recovering well from the 2020 stock market crash. But I think the likely return of dividends in 2021 makes it look still cheap.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

The FTSE 100 had a cracking November, gaining 689 points, or 12%. And just nine days into December, the top UK index has already climbed a further 320 points for another 5%.

But these are unusual times. And this short-term success stands against the Covid-19 ravages of 2020. But are FTSE 100 share prices still good value, and what would I do now? Looking to the long term, I do think our top shares are currently undervalued. It’s hard to put many meaningful numbers on anything right now. But there is one key measure that I find increasingly valuable, and that’s the FTSE 100 index dividend yield.

As we entered 2020, analysts were predicting a 4.7% yield for the year. On the face of it, I think that made the index look cheap. For one thing, it’s a high yield relative to long-term levels. And, as a weighted average across all 100 shares, it covers companies not paying any dividend plus those offering small yields and reinvesting in growth instead. So picking from only those stocks considered long-term income investments, it’s possible to do significantly better than the average.

Dividend valuation

But looking a bit deeper, that attractive-looking 4.7% yield hid a disturbing trend. In recent years, a growing number of FTSE 100 companies have been raising their dividends faster than their earnings. That means dividend cover has been falling, and I don’t see that as a very prudent approach. It makes future dividends potentially less reliable, and diminishes a company’s ability to weather any financial storms coming along in the future. And there are always financial storms coming along in the future.

Speaking of storms, nobody expected the tempest brought by the Covid-19 pandemic. But dividends have tumbled as a result, with banking dividends among the first to fall. That was at the behest of the regulator, but I reckon it was wise move anyway. I do think the FTSE 100 banks were getting a little ahead of themselves in providing progressive dividends. Even though they were passing the Bank of England’s stress tests comfortably, there wasn’t much cover kept in reserve to cope with, for example, further Brexit weakness.

FTSE 100 in 2021?

The overall result has been a big drop in the anticipated FTSE 100 index dividend yield. Forecasts now suggest something around the 3.2% mark this year. And as share prices strengthen, so yields fall further. But what is my long-winded explanation saying about my take on the valuation of our top shares?

Well, the 2020 dividend downturn is surely only temporary. The banks will be keen to get back to paying out the annual cash. A good few other companies have not suffered as badly as they might, and we will presumably see their dividends coming back too.

So I expect the FTSE dividend yield in 2021 to be nicely ahead of 2020. I do hope we see a more conservative approach in the future. But I can easily see an overall yield approaching the 4% mark. On that assumption, I think the FTSE 100 is undervalued. I’m buying.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Views expressed 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.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »