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

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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.

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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.

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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.

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