7%+ yield and a booming share price! Should I scoop up Taylor Wimpey shares?

On the hunt for good income stocks to add to my portfolio, I’ve been thinking about the pros and cons of homebuilders. Taylor Wimpey (LSE: TW). With a dividend yield of 7.4%, the company can tick the income box. Shares in Taylor Wimpey have been steadily rising since late September. They are up over 40% at that time.

However, that still leaves the Shares 20% below where they were last year and trading at a price-to-earnings ratio of only 8.

So, could it be an offer to take my portfolio?

Shift in cash flow

To pay dividends consistently, a company must generate excess cash.

Taylor Wimpey has hit the nail on the head when it comes to profits. In the interim results, profits were flat at the operating level but profit before tax increased by 16% compared to the previous year period. At £335m, they are substantial.

The cash flow picture is not pretty. The period saw negative free cash flow of £193m.

Some £151m of that covers share buyback costs. But even without that, the company didn’t generate enough free cash flow in the first half to cover the dividend. On a short-term basis this is good, but in the long-term, negative free cash flow can signal a risk that the dividend could be cut.

Vision of the future

However, negative free cash flow in the interim may not be a sign of things to come. By 2021, the company is generating around £100m in free cash flow even after paying a £300m dividend. Last year’s buyback program increased negative free cash flow, but it may have been one.

Buybacks can unlock long-term value for shareholders if companies can buy them at low prices and reduce the number of shares in circulation. That could boost earnings per share as well as free cash flow per share in the coming years, setting the stage for dividend increases.

Dividend prospects

Indeed, at the interim stage the company increased its dividend by 12% compared to the previous year. Given the resilient performance of post-tax profits, I think dividends are likely to increase in the coming years, possibly starting with the publication of last year’s final results early next month.

But one red flag in the interim stage that, although profits grew, there was a 5.4% year-on-year decline in revenue. If house prices fall, the profits of home builders can follow. That can be bad news for profits and cash flow. That could lead to lower payouts for Taylor Wimpey shareholders.

My movement

I have to admit, I like the look of the stock. The business is established, trading at attractive valuations and has good and substantial profits.

But I remain nervous about the prospects for the housing market. Shares in Taylor Wimpey rose sharply, but are still 35% lower than they were five years ago – and more than two-thirds below their peak in 2007 before the financial crisis. So for now, I will wait and see how the housing market performs in the month and next before doing anything.