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Is Inter Pipeline Ltd.’s (TSX:IPL) 7.3% Yield Worth the Risk?

Inter Pipeline (TSX:IPL) currently pays investors a dividend of 7.3%, and with monthly payouts, it could be a great source of cash flow for any portfolio. However, before you decide to buy Inter Pipeline for its dividend, there are some important things you should consider.

Is the dividend safe?

When investors look at the strength of a dividend, they’re often looking at a company’s payout ratio and whether it is sustainable or not. After all, a good yield isn’t worth much if it’s likely to be cut, and the uncertainty prevents you from being able to simply “buy and forget.”

One method of calculating the payout ratio considers the stock’s earnings per share (EPS). Under this approach, we would take Inter Pipeline’s annual dividend per share of $1.68 and divide it by the company’s EPS of $1.49, which would result in a payout ratio of 113%.

Any time you’ve got a payout ratio higher than 80%, you should have a second look at the dividend. A payout of over 100% means that the company is paying out more than it is bringing in by way of earnings. The problem, however, is that depreciation and other non-cash items will impact earnings, especially in oil and gas where companies have a lot of money tied up in big assets.

This is where a second approach can prove to be more useful, and that’s calculating payout ratio as a percentage of free cash. Free cash is what a company has available after paying its bills and investing in capital, and is what it can use to pay dividends, make investments, or simply stockpile the cash for a future use.

In the trailing 12 months, Inter Pipeline has generated $534 million in free cash while paying out $319 million in cash dividends for a payout of 60%. This is a big disparity between the payout ratio using EPS, but it’s easy to see why that would be the case as the company incurred $269 million in depreciation expenses. This would have had a negative impact on EPS and helped pushed the payout ratio in that calculation to over 100%.

Overall, if we look at payout ratio, Inter Pipeline doesn’t raise any concerns for me given it is generating ample free cash flow.

What about the industry?

While Inter Pipeline may be in good shape, the oil and gas industry as a whole is a separate issue. There have been many challenges over the past year in getting pipelines approved, and many companies have grown frustrated with the hurdles and red tape that have prevented growth in the industry.

Oil prices have improved from a year ago, but you wouldn’t know it from Inter Pipeline’s stock price, which has fallen 11% year to date and is flat from a year ago. If conditions don’t improve, it would be hard to justify investing in Inter Pipeline due to the uncertainty that exists in the industry.

Bottom line

If you’re willing to take on the risk of investing in oil and gas, then Inter Pipeline is a great choice. However, if you’re looking for a safe place to put your money, then other dividend stocks might be more appropriate.

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Fool contributor David Jagielski has no position in any of the stocks mentioned.

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