Financial services and asset management firm Legal & General (LSE: LGEN) shares paid a dividend last year of 20.34p.
This yields 9.5% on the current £2.15 share price. By comparison, the average yield of the FTSE 100 is just 3.6% and of the FTSE 250 only 3.3%.
So, £9,000 (the amount I started investing with 30 years ago) would buy me 4,186 Legal & General shares today. At a yield of 9.5%, these would generate £855 in dividends in the first year. Over 10 years on the same average yield these would rise to £8,550 and over 30 years to £25,650.
A better return than could be had from a UK savings account certainly. But even more could be made by using a standard investment process called ‘dividend compounding’.
What’s the point of dividend compounding?
This method aims to produce exponentially higher returns over time than can be achieved otherwise. It is achieved by using the dividends paid by a stock to buy more of it. And the effects are astonishing.
For example, the same £9,000 at the same average 9.5% yield would make me £14,185 after 10 years, not £8,550. And over 30 years on the same basis, I would make £144,854 rather than £25,650.
Adding in the initial £9,000 investment would give a total value of the holding of £153,854. On the same 9.5% yield, this would pay me £14,616 a year in passive income. This is money made from minimal effort, as with share dividends.
Is a high yield sustainable?
A company’s dividends and share price are powered by earnings growth over time and may go up as well as down. A risk for Legal & General is any resurgence in the cost of living, which may prompt customers to close accounts.
Another is a recurrence of the sort of market jitters seen in the mini-financial crisis in March/April 2023. This makes generating steady investment returns more difficult to achieve.
However, analysts forecast that Legal & General’s earnings will grow a stellar 28% each year to end-2026.
Given this, the projections are that it will be able to at least match its promised rises in dividend payments over the period.
Back in June, the firm announced it would increase its dividend this year by 5%. That would bring the total payment to 21.36p, yielding 9.9% on the present share price.
For 2025 and 2026, it pledged a 2% annual increase, lifting respective dividends to 21.78p and 22.22p. On the current share price, these would generate yields of 10.1% and 10.3%.
Are the shares also undervalued?
Provided that the shares maintain a high yield (which isn’t guaranteed) – regardless of share price – I would never sell them. However, if I did have to for some reason then I would rather not lose money on the price.
To reduce the chance of this happening, I only buy shares that look undervalued to me. And Legal & General fits the bill here.
A discounted cash flow analysis using other analysts’ figures and my own shows the shares are currently 61% undervalued. So a fair value for them is £5.51, although they may go lower or higher given market unpredictability.
Given their strong earnings growth prospects, exceptional yield, and undervaluation, I will buy more Legal & General shares very soon.
This post was originally published on Motley Fool
