Should you buy Coles shares for that hefty 6% dividend yield?

Should Coles stock go in your shopping basket?

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Coles Group Ltd (ASX: COL) shares have provided investors with a growing stream of dividends over the last few years. The Coles share price has fallen 10% in the past year, as seen on the chart below, making the dividend yield more compelling.

When a share price drops, it boosts the yield. For example, if a business with a 5% dividend yield suffers a 10% share price fall, the dividend yield becomes 5.5%. As a bonus, the lower Coles share price results in a more appealing price/earnings (P/E) ratio.

Firstly, let's look at the passive income potential.

Is the Coles dividend yield appealing enough?

The ASX supermarket share has grown its annual payout every year since it started paying dividends in 2019. There aren't too many S&P/ASX 200 Index (ASX: XJO) shares that have grown their payouts through the COVID-impacted year of 2020 and during the inflation-hit years of FY23 and FY24.

According to the estimate on Commsec, Coles shareholders are forecast to receive a dividend per share of 67 cents. This translates into a fully franked dividend yield of 4.1%, or around 6% grossed-up with franking credits.

As a comparison, the Vanguard Australian Shares Index ETF (ASX: VAS) has a partially franked dividend yield of 3.7%, according to Vanguard.

In my opinion, Coles shares offer a dividend yield that's stronger than the market.

But, there's more to shares than just the passive income – earnings growth and capital growth are also important factors.

Earnings growth is forecast

I believe earnings growth is the crucial driver of share prices over the long term.

The most recent update from the company showed the business is going in the right direction.

In the third quarter of FY24, Coles reported supermarket sales growth of 5.1% and total sales growth of 3.4%. Revenue is usually a key input for profit growth, so it's pleasing to see the supermarket segment's revenue still growing at a solid pace despite the reduction in inflation. Coles reported third-quarter inflation of 2.2%, compared to 6.2% inflation in the third quarter of FY23.

While Coles is facing higher costs, particularly wages, it's still forecast by analysts to generate earnings growth in the next few years.

According to Commsec, Coles' continuing operations earnings per share (EPS) are forecast to grow 3.7% in FY24 to 81 cents. FY25 EPS is predicted to rise another 4.4% to 84.6 cents, and FY26 EPS is forecast to grow 12.8% to 95.4 cents.

These numbers put the Coles share price at 20x FY24's estimated earnings and 17x FY26's estimated earnings. Profit is predicted to go in the right direction.

I think there are a number of positives for Coles' earnings in the medium term, so I'll mention two. The Australian population keeps growing, which means more potential customers. The new Coles distribution warehouses are getting closer to completion, which will help margins and efficiencies once operational.

Coles shares are a buy, in my opinion, for both the pleasing dividend and the prospect of growing profit in the years ahead.

Motley Fool contributor Tristan Harrison has no position in any of the stocks mentioned. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has positions in and has recommended Coles Group. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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