I’ve held my Tesco (LSE: TSCO) shares for years, a permanent fixture in a portfolio aimed at earning a second income. However, it’s fair to say the group’s relatively low yield means it’s often glossed over by dividend investors.
Since 2023, the yield’s steadily declined from over 5% to 3.2% — barely above the FTSE 100 average. So does the recent 12.9% increase mean the company’s keen to regain its place as a top dividend pick? And more importantly — does it have the cash to keep up payments? Let’s take a closer look.
The dividend proposition
Tesco’s generous dividend policy presents a mixed but increasingly attractive picture for income investors. The most recent increase follows a similar 13.2% raise last year and an 11% increase in 2023.
At this rate, the 2026 final dividend could break a new record above its 2013/2014 peak of 14.7p per share.
That’s what caught my attention — not so much the yield, but the growth trajectory. With dividends increasing that rapidly, City analysts forecast a potential 15.7p per share in 2027. If that projection materialises, Tesco’s dividend would have increased by 57% from the pandemic-era 10p it paid in 2021.
That’s a remarkable recovery, indicative of management’s commitment to shareholder returns.
But is it sustainable?
When considering dividend stocks, sustainability matters more than yield (in my opinion). In this arena, Tesco demonstrates considerable strength across multiple metrics.
The mighty grocer’s payout ratio stands comfortably around 60%, leaving substantial room for further increases without limiting reinvestment in the business. This kind of healthy balance is critical — neither too conservative nor too aggressive. Leaning too far in one direction risks hurting the business or disappointing shareholders.
Importantly, the dividend’s covered more than four-fold by free cash flow, providing a significant safety margin. Show me a 9%- or 10%-yielding stock with insufficient coverage and I’m still picking a stock like Tesco every time.
So what’s the catch?
Suffice to say, I think Tesco’s a top dividend stock to consider for a second income portfolio. But, as always, no investment comes risk-free.
The primary risk to Tesco’s dividend sustainability is relentless competition in the UK grocery market. Like most, it already has razor-thin margins, and they’re constantly under pressure from discounters like Aldi and Lidl.
Constant price matching combined with a rising National Living Wage is already threatening profits. Any notable decline in consumer spending could hurt profits and put the dividend at risk.
The bottom line
When investing with a long-term outlook, it doesn’t matter what the yield is today. You’re buying a stock at today’s price, so what matters is how much the dividend will pay out in three, five, or 10 years.
An 8%-yielding stock that’s likely to fall 50% over the next decade is nothing but a value trap. Tesco, on the other hand, looks on track to keep rising. Sure, there are risks – there always are – but its long-term sustainability looks more favourable than most.
That said, markets change and companies falter, so don’t focus on one stock. The UK market’s full of promising income shares just like Tesco, so dig out some other gems to help reduce sector-specific risk.
This story originally appeared on Motley Fool
