When we invest with the aim of building up a passive income stream, it’s the dividend yield that counts, right? As long as that’s good, why should the price-to-earnings (P/E) ratio matter?
Well, I might invest mainly for dividend income. But that doesn’t mean I’d pass up any share price gains from a potentially undervalued stock.
No, I’d consider that a nice bonus, which could give me a healthy boost should I decide to sell some shares in the future.
Cheap, with dividends
The best kind of company to consider buying for passive income, surely, is one that combines both valuation measures. I’m talking about strong dividend forecasts, plus a low P/E valuation.
The one I have in mind today is NatWest Group (LSE: NWG). The share price is actually up 54% in the past five years.
But that still gives us a forecast P/E of just 7.8 for this year, which is only around half the FTSE 100 long-term average. Oh, and it could drop to around 6.8 based on 2026 forecasts.
And the forecast dividend yield is still a solid 4.9%, growing to 5.8% by 2026.
It’s cover that counts
We might not best serve our long-term passive income goals by chasing the very biggest dividend yields.
Vodafone is a good example, on a forward yield of 10.4% for the current year. But after years of not being able to cover the dividends by earnings, Vodafone plans to slash its 2025 payout in half.
Those uncovered dividends might have looked good while they lasted, but nothing comes free. And Vodafone shareholders have paid with a 73% fall in their share price in the past 10 years.
The shine of a fat dividend can soon wear off if the cost is nearly three-quarters of our capital… and then the income is halved.
There’s always a risk that NatWest could cut its dividend in future too. And that’s the number one reason why I say a passive income portfolio needs to be well diversified.
Cash stream
For now, at least, the NatWest dividend looks to be well covered by forecast earnings. In fact, analysts expect cover of 2.5 times for this year.
And even with dividend growth expected, cover would stay around that level by 2026 if these forecasts turn out to be accurate.
How long these dividends can keep going at this strength is an open question. Do I think the UK has seen its last ever banking crisis? I’d say almost certainly not. And falling interest rates could hit NatWest’s lending margins.
Still, the interim dividend was lifted by 9%. And at Q3 time, the board said it expects “to pay ordinary dividends of around 40% of attributable profit“, while still leaving room for possible share buybacks.
Bottom line
I’d never put too much cash into one income stock. And the banking and finance sector can suffer unduly when the economy is weak.
But for my next passive income investment, while keeping decent diversification, NatWest is among my top candidates.
This post was originally published on Motley Fool
