Should I buy Legal & General shares for a 9.5% dividend yield?

Legal & General (LSE: LGEN) shares are expected to pay out 21.3p per share in dividends for the 2024 financial year. At today’s share price of 225p, that equates to a yield of 9.5%.

Should I buy the shares to pick up this monster yield (and generate a ton of passive income)? Or are there better opportunities in the stock market for me today? Let’s discuss.

Are the shares undervalued?

When a stock has an unusually high yield like this, there are usually two possible explanations.

One is that the stock is undervalued.

That could be the case here. Currently, Legal & General has a price-to-earnings (P/E) ratio of about 11.1, which is quite low (the FTSE 100 average is about 14).

It’s worth noting that analysts at JP Morgan have a price target of 290p for the shares. If they were to rise to that level, the yield would fall back to a less extreme 7.3%.

Is there something wrong with this one?

The other explanation, however, is that there’s something wrong with the stock and the ‘smart money’ has dumped it (pushing the share price down and the yield up temporarily).

Now, at first glance, I can’t see anything fundamentally wrong with the business. Recent H1 results showed a stable core operating profit along with a high Solvency II coverage ratio of 223% (indicating that the firm is financially strong and well-positioned to handle unexpected losses).

But it’s worth noting that in July, analysts at RBC downgraded the shares to a ‘sector perform’ rating from ‘outperform’, citing potential competition in the bulk-purchase annuity (BPA) and pension risk transfer (PRT) markets. As a result of the competition, the analysts made material cuts to their operating profit forecasts, and reduced their share price target by 50p to 245p.

We have less conviction on Legal & General shares from here.

RBC analysts

This is an interesting take. If Legal & General’s operating profit was to fall going forward, we could potentially be looking at lower dividend payments in the future (and a lower share price).

One thing worth mentioning here is that dividend coverage (the ratio of earnings to dividends) isn’t high. In fact, it’s very low.

With the consensus earnings per share forecast for 2024 sitting at 20.5p, the dividend coverage ratio is 0.96. A ratio below one can be a warning that a dividend payout isn’t sustainable.

Should I invest in Legal & General today?

Putting this all together, I’m going to leave Legal & General shares on my watchlist for now.

There’s no doubt that the 9.5% dividend yield looks interesting.

But there are a few risks to be aware of here and the low level of dividend coverage isn’t ideal.

Taking a long-term view, I think I might be able to obtain higher returns elsewhere in the market.

The post Should I buy Legal & General shares for a 9.5% dividend yield? appeared first on The Motley Fool UK.

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Edward Sheldon 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.