With its 7% dividend, should I be watching the Aviva share price?

For income-seeking investors, few things pique interest more than a big dividend yield. British insurance giant Aviva (LSE:AV.) certainly catches the eye with its trailing 7% dividend payout. But before rushing in, it’s crucial to analyse whether this high yield is built on solid foundations or could be a warning signal. Let’s take a closer look.

The dividend

Aviva’s current annualised dividend of £0.33 per share equates to an appealing 7.01% dividend yield at the current share price. This towers over the average yield of around 3%-4% for the wider FTSE 100 index.

However, while the yield appears mouthwatering on the surface, one risk factor is that Aviva’s dividend may not be well covered by the company’s cash flows and earnings. The payout ratio sits at an elevated 89%, suggesting a massive portion of profits are being distributed to shareholders.

Typically, a payout ratio above 70%-80% could indicate a dividend that’s becoming unsustainable if business conditions deteriorate. This makes the dividend riskier compared to insurers with lower payout ratios and higher profit retention.

Promising signs

That said, there are some compelling reasons why income investors may want to keep an eye on the Aviva share price as a potential buying opportunity. Most notably, the stock appears significantly undervalued based on a discounted cash flow (DCF) calculation.

The firm is currently trading at a whopping 40% below the estimated fair value calculation. This disconnect means the market may be failing to properly appreciate the insurer’s future earnings power and cash flow generation capabilities following recent restructuring initiatives and cost cuts.

Additionally, Aviva became profitable again in 2023 after some challenging years. With forecast earnings growth of 9% annually, the company’s dividend affordability could improve markedly.

The share price has actually seen some fairly strong movement in the last year, up 18%, and easily outperforming the UK insurance sector, which declined by 10% over the same period.

Risks

However, investors need to be aware that the insurance sector faces several headwinds that could derail the bullish investment case. The company operates in a very regulated industry where capital requirements, compliance costs, and litigation threats are always looming risks.

There are also concerns around elevated claims from climate change, natural disasters and the ongoing impact of higher inflation eating into profit margins. The UK’s economic outlook remains clouded by persistent cost-of-living pressures as well.

Solvency is another metric insurance investors closely monitor. But as of the latest report, Aviva held an estimated solvency ratio around 212%, providing a comfortable buffer over regulatory minimums although still lower than some peers.

Overall

All things considered, I feel the firm presents a strong-but-higher-risk opportunity for dividend investors willing to stomach some volatility. The 7% yield is certainly eye-catching, but it’s backed by a high payout ratio that makes the Aviva share price extremely vulnerable if earnings disappoint. I think it deserves a place on my watchlist, but I’ll not be investing for now.