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With a dividend of 18%, is this UK share too good to be true?

Photo of a man going through financial problems
Photo of a man going through financial problems

My desire to build an income-generating portfolio often leads me to look for the best UK dividend shares. I’m normally tempted to look for stocks offering the highest yields as these have the potential to provide a great source of income. However, the dividend isn’t the only factor to consider. Without solid fundamentals and a good track record of payment, no stock would be a positive addition to my portfolio.

The FTSE 350 average dividend is 4%, so I’m always intrigued when I find a company offering above this level. This is certainly the case with Persimmon (LSE: PSN), the second-largest housebuilder in the UK. It’s currently offering an astounding dividend yield of nearly 18%. This is considerably above the index average and a tempting investment opportunity.

Explaining the yield

After a fairly stable share price over the last couple of years, this has appeared to reverse significantly. In 2022 the share price has fallen 56.2%. It’s also down over 60% from pre-pandemic levels, which contributes to the elevated yield. Consequently, the current price-to-earnings (P/E) ratio is just 5.3, almost half the FTSE 350 average, which could indicate that it’s an undervalued opportunity.

The impact of this fall in price on the dividend yield can be understood by looking at previous years. It’s useful to look at the average yield paid over the last few years as this shows me whether a high dividend has been paid consistently or has peaked recently. For Persimmon, the yield grew from 4.1% in 2019 to 8.5% in 2020. And it reached almost 18% this year. This indicates that the share price fall is what has driven the yield so high.

Underlying fundamentals and headwinds

Despite this, many of the core fundamentals of this stock are appealing. Profit margins are good at 26.9%, and free cash generation has risen above its three-year average. The company is also efficient at generating profit from its invested capital, as demonstrated by a significant return on capital employed (ROCE) ratio.

But given that this company operates within the housing sector, there are several sector-wide headwinds that I’m concerned about. The risk of reduced demand and house price falls could continue hurting the stock price. And despite a significant recovery in 2021, bottom line profit is still below pre-pandemic levels.

So, I’m not tempted to add Persimmon to my portfolio at this stage due to the risks facing the company over the next few months. However, it’s on my watchlist, as the high dividend is certainly very tempting, especially if this elevated level remains in future years. Therefore I may consider including it in the income portion of my portfolio if I gain more certainty about the wider economy, and get the necessary funds.

The post With a dividend of 18%, is this UK share too good to be true? appeared first on The Motley Fool UK.

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Gabriel McKeown has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned 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.

Motley Fool UK 2022