When investors want to buy dividend stocks, one of the factors many often consider is how significant the yield is. That’s why a stock like Freehold Royalties (TSX:FRU) is so popular, considering it currently offers a yield of more than 7%.
However, while it’s understandable why investors want to buy stocks that have significant yields and can return a tonne of passive income, the size of the yield is not the most important thing to consider.
Dividend sustainability is key
It’s far more important to first ensure that the dividend is sustainable. Otherwise, it doesn’t matter how high the yield is today since it could be at risk of being cut tomorrow. And when companies cut their dividends, it not only means less income for you. It could also result in a significant sell-off of the stock.
So while you can look for high-yield stocks to buy, it’s even more important to ensure that the companies you’re looking to buy can sustain their dividends.
Another factor to consider is a stock’s growth potential. While a 7% dividend yield for Freehold Royalties can seem attractive due to its significance, if the stock pays out all of its earnings each quarter, there will be no cash left to invest in growing the business.
And while a 7% dividend may be attractive, over the long term, you could earn a far better return by buying a stock with a 5% dividend that is consistently growing its earnings each year by 5% as well.
Therefore, while high-yield dividend stocks like Freehold Royalties can look attractive, it’s essential that investors do their due diligence. Specifically, ensure the stock can sustain its payouts and is a high-quality, long-term investment.
So with that in mind, let’s look at how sustainable Freehold Royalties dividend is and whether the stock is worth investing in for the long haul.
Is Freehold Royalties stock a good investment today?
Before we analyze Freehold Royalties stock and its attractive dividend yield, it’s essential to understand how its core business operations work and how the stock generates the cash that it uses to fund the dividend.
Freehold owns the land that many other energy stocks use to produce oil and gas. In exchange, the stock receives a royalty on every barrel of oil equivalent that other companies produce on its land.
This gives Freehold a lower-risk business model than many of its energy-producing peers for a few reasons.
First, it has an asset-light business model and doesn’t have to worry about some of the risks or setbacks that producers face. In addition, because it’s an asset-light business model, it also doesn’t have nearly as high of capex requirements each year, allowing it to earn tonnes of free cash flow (FCF).
Furthermore, with hundreds of different companies using its land, the stock’s revenue is well-diversified. It does have exposure to the price of oil and gas, as does almost every energy stock, but in general, it’s a lower-risk company that’s constantly generating millions in cash flow each quarter.
Therefore, the FCF it generates goes straight to funding the dividend, with any leftover cash retained by Freehold Royalties stock. This cash is allocating to acquiring new land down the road, to ultimately expand its portfolio and continue growing the business.
So with that in mind, we can easily compare the dividend payments to Freehold’s FCF to see how sustainable the dividend is.
Is the dividend sustainable?
In general, Freehold Royalties stock targets a payout ratio of between 60% and 80% of its FCF. The company wants to pay at least 60% because it’s a stock targeted toward dividend investors and should provide an attractive yield.
However, Freehold also wants to pay less than 80% of its FCF to keep a margin of safety in case it experiences a few down quarters, as well as to retain cash to invest in future growth.
So with Freehold paying out $1.08 per share this year in dividends and analysts expecting it will earn FCF per share of $1.58 in 2023, the stock has a current payout ratio of just 68%.
Plus, in each of the next four years, Freehold is expected to earn more FCF than in 2023, showing its impressive 7.1% dividend yield looks to be sustainable for years to come.
