When a stock on the TSX offers an attractive dividend yield, it immediately grabs attention. That naturally makes sense. The higher the yield, the cheaper a stock is trading and the more passive income potential it offers.
But high yields aren’t universally positive. In fact, a high yield can mean one of two things. Either the company is generating strong, sustainable cash flow and is returning a significant portion of it to shareholders, or the market is pricing in risk, and the dividend may not be as safe as it looks.
That’s why when you see a yield as high as 6.1%, the first question to ask is what the company does and can its operations sustain that dividend yield.
However, when it comes to Freehold Royalties (TSX:FRU), one of the best dividend stocks on the TSX, the numbers suggest that its dividend yield is far more sustainable than many investors might realize.
Source: Getty Images
A different kind of high-yield TSX stock
The first thing to know about Freehold, and why it’s such a high-quality dividend stock, is that while it’s an energy stock, it’s not a traditional oil and gas producer.
So instead of drilling wells and taking on the operational risks that come with exploration and development, Freehold owns royalty interests on energy-producing lands. That means it collects a percentage of revenue generated by operators without having to fund drilling costs itself.
This is essential to understand because the royalty model it uses leads to lower capital intensity and more predictable free cash flow. Unlike traditional energy producers, Freehold doesn’t need to constantly reinvest billions just to maintain production.
Instead, the stock simply collects royalties from a diversified portfolio of assets across North America, which is what allows it to return so much cash to investors and offer one of the most attractive yields on the TSX.
What the payout ratio actually tells us
Right now, while Freehold offers a compelling dividend yield of roughly 6.1%, which is well above average yields on the TSX, its current payout ratio sits at approximately 73%.
That’s important because Freehold consistently leaves itself a significant margin of safety since commodity prices tend to be volatile.
In fact, that margin of safety is so significant that Freehold believes that its dividend yield would remain sustainable even if WTI oil prices fell to just $50 per barrel, a level we haven’t seen since early 2021, at the height of the pandemic.
In fact, management has stated that it targets a 60% payout ratio over the long term. That means the current payout level isn’t wildly out of line and goes to show why a large margin of safety is so important for Freehold and its investors.
Plus, when oil prices rise rapidly, which we’re already seeing as a result of the military escalation in the Middle East, royalty stocks like Freehold can see a significant increase in cash flow.
Furthermore, since Freehold doesn’t pay out all of its cash flow, the stock is consistently building a cash pile which, over the long haul, it can use to acquire more land and expand its operations, leading to more growth down the line.
Therefore, that conservative payout ratio doesn’t just make its 6.1% yield one of the most reliable high yields on the TSX; it also gives Freehold significant long-term growth potential.
