The power of collecting dividends in a tax-free account cannot be overstated. Allow me to demonstrate just how much extra return you’ll end up with versus more traditional investment choices.
Say you make $100,000 per year and you’re looking to invest, so you buy a bond yielding 7% in a fully taxable account. Depending on what province you live in, you’re looking at a tax bill of between 36% (Alberta) and 45.7% (Quebec) on any interest earned on that investment. Your 7% yield is now in the 4-4.5% range, depending on where you reside.
Compare that to getting the same amount in a dividend, also in a taxable account. The dividends would be taxed at a 15% marginal rate in Alberta, all the way up to a 29% marginal rate in Quebec. This puts the after-tax yield of the investment in the 5-6% range. That’s much better than getting interest.
Finally, let’s take a closer look at the tax treatment of a 7% dividend inside of a TFSA. The TF part of that investment stands for tax free, which means an investor is keeping every nickel of their dividends. Now we’re talking.
That’s the beauty of a tax-free savings account. Now the only thing left for an investor to do is find the best dividend payers for their accounts. I have just the stock.
A green alternative
TransAlta Renewables Inc. (TSX:RNW) offers it all. It gives investors a chance to invest in a rapidly growing industry, a reasonable valuation, and a succulent dividend. What more could a TFSA saver want?
The company owns power generation assets spread across Canada, the United States, and Australia. It has 47 different power plants with total generation capacity of 2,412 megawatts. That’s enough to power nearly 500,000 homes.
The majority of its cash flow comes from seven natural gas-fired plants, which are primarily located in Australia. 47% of cash flow comes from these assets. Next up are Renewables’ 21 wind-fueled facilities, which are spread across North America. These account for 46% of cash flow. The company also has hydro and solar-powered assets.
Renewables has two growth paths going forward. It can build new plants to replace aging coal-fired power assets spread across the developed world. Or it can buy assets from its parent company, TransAlta. The parent owns 61% of its subsidiary, so it has incentive to give it first crack at assets that hit the auction block.
TransAlta Renewables has grown significantly since its 2014 IPO. It generated $82 million in cash available for distributions that year. 2019’s number should be close to $300 million. This growth, along with savvy capital allocation by the company’s management team, has led to a total return in excess of 100% since the IPO.
Despite this success, shares are still relatively cheap. The company’s market cap is $3.6 billion, putting shares at just 12 times expected cash flow. This is a very reasonable valuation to pay for such fine assets.
A fantastic dividend
There aren’t many dividends that give investors close to a 7% yield while offering dividend growth. But TransAlta Renewables delivers on both fronts.
Let’s start with the yield, which is 6.8% today. Renewables generated $295 million in cash flow in 2018. It paid out a little under $250 million in dividends, which gives us a payout ratio of 84%. There’s nothing wrong with that.
Next we’ll look at the growth of the payout. Although the dividend has been left at $0.94 per share since 2017, Renewables can still boast a 5% annual growth rate in the payout since the 2014 IPO. And with a couple new projects coming online later this year, I’d expect the company to give investors a small raise toward the latter part of the year.
The bottom line
TransAlta Renewables has a lot going for it. It’s a leader in a great growth industry. It has a solid balance sheet and sharp management team. And perhaps most important, it has one of Canada’s best dividends. It’s the perfect stock to stash in a TFSA and forget about for 10 or 20 years.
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Fool contributor Nelson Smith owns shares of TRANSALTA RENEWABLES INC.