An 8.7% dividend yield means Legal & General (LSE:LGEN) shares have the potential to turn a £20,000 investment into a £1,740 a year second income. But is this too good to be true?
The FTSE 100 firm has returned consistent dividends and I don’t see a major threat on the horizon. I do think, though, that investors need to look more closely at what’s been going on.
Dividend growth
Legal & General has been a passive income titan over the last 10 years. It’s been very consistent in returning cash to investors each year, even during the Covid-19 pandemic.
That doesn’t happen by accident and dividend investors might well think that all is well as long as the firm keeps finding a way to distribute cash, all is well. But I’m not so sure.
Since 2022, Legal & General has been making less in net income than it’s been returning to shareholders. And this doesn’t look like something that can go on indefinitely.
Despite the shortfall, I don’t think the firm’s distribution is in any immediate danger. But this is why investors need to focus on more than just the dividend.
How it works
The obvious question for anyone thinking of buying Legal & General shares is where the cash for the dividend is coming from. And there’s good news and bad news on this front.
It’s coming from the firm’s balance sheet. The company has capital reserves well in excess of what it needs to meet its solvency requirements and it can use these to support its dividend.
The good news is that this can go on for some time – Legal & General has over £9bn in excess capital and currently returns around £1.25bn a year. So I don’t see a threat for a while yet.
The bad news is that using the firm’s assets to support shareholder distributions reduces the firm’s intrinsic value. And this has been showing up in the company’s share price.
The bigger picture
Since the start of 2022, Legal & General has returned just under 81p per share in dividends to investors. But the share price has fallen by 61p during that time.
As a result, investors who bought the stock three years ago are – on a total return basis – up just under 7% in total. That’s not a great result and it’s no accident the stock has gone down.
Legal & General sticking by its dividend has come at the expense of the company’s intrinsic value. And the stock market has been recognising this in its view of the firm’s share price.
This is why investors need to focus on more than just the dividend. No company has a magic way of returning more cash than it makes and the effects start to show up sooner or later.
A FTSE 100 heavyweight
Legal & General has been in the FTSE 100 since before I was born and I suspect it’ll be there after I’m gone. Given this, an 8.7% dividend yield looks pretty attractive.
I think, though, that investors targeting a second income need to look a bit closer. With my own portfolio, I’ve found other opportunities that look better to me.
