UK investors are known for favouring reliable FTSE 100 dividend stocks for passive income. Many of these companies aim to be the top-picked stock by ensuring their shareholders receive a consistent return.
These companies typically pay well above the 3.5% average yield. A well-balanced portfolio of such stocks has long been the preferred strategy of investors with a long-term view.
One of the most popular dividend-paying stocks in the UK is financial services provider Legal & General (LSE: LGEN).
Financials
The insurance giant is focused on the retirement market, a large industry that typically enjoys high demand. However, it faces risks from economic downturns, policy withdrawals and weak investment decisions. These factors can all affect the company’s performance and hurt the share price.
For now though, its financials look good.
Currently at 45 times earnings, the price may appear somewhat overvalued. Yet with strong cash flows, it’s estimated to be trading at 60% below fair value. Plus earnings are forecast to grow at a rate of 27% per year, so the price-to-earnings (P/E) ratio should decrease.
But if earnings falter, it could be in trouble, as it has a lot of debt to pay off.
Let’s look at dividends
I hold the stock in my portfolio as one of several shares from which I receive dividends. I also choose to reinvest the dividends, therefore growing my investment and compounding my returns.
This is a particularly effective strategy with Legal & General due to its solid dividend track record. It’s been increasing its annual dividend consistently since 1998, with only a brief reduction in 2008 and 2009.
So what if I had £10,000 to invest in the stock right now with the aim of earning passive income? How much could I expect to receive?
Let’s find out.
The power of reinvesting dividends
It’s impossible to predict exact returns but we can try to make some estimates. Past performance, while not an indication of future results, can give some insights. By evaluating how well a company performed during past economic periods, we can assess its average return.
Income stocks tend to grow slowly but experience less volatility than growth stocks. This is typically reflected in the price which, in Legal & General’s case, is down 20% in the past five years. However, the total return over five years with dividends reinvested is 17.5%.
Over 10 years, the total return is a massive 79.69% even though the price is down 7.7%. In the past 20, it’s 554%, even though the share price increased only 110%.
This reveals how effective reinvesting dividends can be.
The nest egg
From the above, I can calculate the stock provided an average annual return of 9.84% over the past 20 years, with dividends reinvested.
A £10,000 investment would therefore hypothetically return around £984 a year. That would cover the cost of a decent holiday each year.
But if reinvested, the pot could grow to £26,673 in 10 years. If it maintained the current 9% yield, that would pay £2,250 a year in dividends.
None of this is guaranteed, of course, and returns could turn negative too. But assuming that doesn’t happen, after 20 years, that figure could have breached £70k, paying an attractive £6,000 a year in dividends. I think that’s good for a relatively small initial investment.
This post was originally published on Motley Fool
