Your Definitive High-Yield Dividend Stock Buying Guide

Investors who are seeking income have several options, including high-yield savings accounts, bank CDs, bonds and bond funds, annuities, and of course high-yield dividend stocks. These options range in safety and yield, with high-yield stocks tending to offer more income potential but with increased risk. However, the trade-off is that in addition to the increased income, high-yield dividend stocks also tend to provide additional upside in the form of dividend increases and capital appreciation.

While there's more risk involved when investors stretch for higher yields, there are safe dividend stocks out there. The key to finding the best high-yield dividend stocks is to focus on those with a strong financial profile (including a low payout ratio) since it reduces the likelihood that a company will need to cut its dividend.

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What is a high-yield stock?

No magic number automatically qualifies a stock as having a high yield. However, the general rule of thumb is that it needs to be above the average of a standard benchmark, such as the 10-year U.S. Treasury note or the S&P 500. Those are moving targets. At the time of this writing, the 10-year Treasury was around 3% while the S&P 500's yield was under 2%, though both have peaked almost to the double-digits as well as fallen close to 1%.

Most investors would consider a stock with a dividend above 3% as high yield, at least in the current market. While that view could change as interest rates rise and investors can earn more on lower-risk alternatives like government bonds, it gives investors a good cutoff point.

Why do some stocks have higher yields than others?

Two main factors determine a stock's dividend yield: the payout ratio and valuation. The payout ratio is the percentage of a company's cash flow that it pays out to investors in the form of dividends. To illustrate, we'll compare the payout ratios of two well-known, high-yield pipeline stocks:

Data sources: Kinder Morgan and ONEOK. TTM = trailing 12 months.

As the table shows, Kinder Morgan has paid out less than 30% of its cash flow over the last 12 months while ONEOK has paid out nearly 75% of its cash flow to investors.

Payout ratios often vary by industry, with tech stocks typically having lower ratios than utilities, for example, because tech companies generally plow a large portion of their cash flow into research and development in order to maintain their position in the market. Utilities often have long-term sales contracts and are able to defend their market share through geographical dominance and the high costs of their established infrastructure, leaving them with more free cash flow for dividends. 

Though as these two pipeline stocks show, even companies within the same industry can have very different ratios. Most high-yield stocks, however, tend to pay out more than half their cash flow each year. While some companies do send back virtually all their cash flow to investors, it's best to target stocks that pay out less than 80% because that leaves some margin of safety, which is some extra wiggle room that will help keep the dividend safe during tough times.  

The other factor playing a role in determining a stock's yield is valuation, which is how much investors are willing to pay for a company's earnings. The more they're willing to pay, the lower the yield, assuming the payout ratios are equal.

We'll use the same two pipeline giants to illustrate this example. While there are many ways to value stocks, the preferred valuation metric for pipeline companies is the price-to-distributable-cash-flow (DCF) ratio, which is the cash they could pay out to investors in dividends. This metric works best because pipeline companies take large depreciation charges against earnings due to the capital costs of pipelines, which typically causes reported earnings to come in well below cash flow and can make pipeline stocks appear more expensive than they really are. Investors can find this number by dividing a company's market capitalization by its DCF (or its stock price by DCF per share). Here's how these two pipeline giants stack up:

Data sources: YCharts, company filings, and author's calculations. Market capitalization as of May 16, 2018. TTM = trailing 12 months.

As the table shows, investors are willing to pay more than twice as much for ONEOK's cash flow as they are for Kinder Morgan's. Because of that, if Kinder Morgan had a higher payout ratio, it would also have a much higher yield. In fact, if both companies paid out 100% of their cash flow, Kinder Morgan would yield 12.5% while ONEOK's yield would only be 4.9%. Among the reasons investors are willing to pay more for ONEOK is that it currently has a stronger balance sheet and is growing cash flow at a faster pace. 

High-yield vehicles worth noting: MLPs, REITs, and BDCs

Another reason some stocks offer higher yields than others is that they have no choice. While most companies can choose how much (or how little) of their cash to pay out each year, three entities don't have that luxury: Master limited partnerships (MLPs), real estate investment trusts (REITs), and business development companies (BDCs). Companies choosing one of these structures must distribute at least 90% of their taxable income to investors. As long as they meet that condition, they aren't required to pay corporate taxes.

MLPs are predominantly in the energy sector where they typically own and operate infrastructure assets like pipelines. These companies make money by charging customers fees for using their assets, often signing long-term contracts with clients for the capacity on their systems. As a result, they generate relatively stable cash flow to distribute to investors.

REITs, on the other hand, normally own commercial real estate like apartments or office buildings. Leases for space in these properties provide REITs with steady cash flow to pay out in dividends.

Finally, BDCs are similar to a venture capitalist in that they provide funding to smaller companies as an alternative to banks or an IPO. BDCs hold debt securities as well as equity in their portfolio companies, which provides them with both income and capital appreciation.

Because companies structured in one of these entities must pay out a significant portion of their income, they carry higher yields as well as higher risk (though many companies using these structures still offer a safe income stream). 

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How to find safe high-yield stocks

Many income-seeking investors are captivated by stocks with high current yields because they see that number as their ticket to a lucrative income stream. Sadly, that's often not the case as higher yields -- especially those in the double digits -- are often a sign of trouble. Instead, investors should see a stock's current yield as a jumping-off point for further research. That study should focus on three things:

• The stability of the company's cash flow.
• Its payout ratio.
• A company's leverage and liquidity.

Cash flow is the foundation for any dividend. For a company to be able to pay a high yield, it needs to generate lots of relatively stable cash flow. Businesses that fall into this category are often those that sell consumer staples (like toothpaste and Band-Aids), those that have a recurring revenue stream backed by contracts or other agreements (think telecom and cable providers as well as pipeline operators), and regulated monopolies like utilities. On the other hand, businesses that operate in cyclical industries like autos and oil companies tend to have lumpier cash flow, making them riskier options for investors because a cyclical downturn can cause cash flow to drop sharply, taking the dividend along for the ride. 

I've already touched on the payout ratio, but it bears mentioning again. The lower this number is, the better, since it means the company not only has an adequate margin of safety on the payout but is generating excess cash to invest in expansion projects, repay debt, or buy back shares. Ideally, investors should look for a payout ratio between 50% to 80% of cash flow since that should enable the stock to offer a sustainable high-yield dividend.

Finally, a company must have a strong financial profile to maintain its dividend, which should include an investment-grade credit rating backed by strong credit metrics. That's because it gives a company greater access to borrowing money at cheaper rates to refinance existing debt, as well as fund expansion projects and acquisitions. Another factor to consider is whether the company has the financial liquidity to meet upcoming obligations such as a near-term debt maturity or an expansion project it has underway. If a company's cash flow isn't stable or it's paying out everything that comes in, it's at high risk for a payout cut if market conditions tighten up just when it needs funds to refinance debt or invest in a big expansion project.

A high-yield stock case study: When cash flow's not enough

To showcase what happens when a company is missing one or more of those factors, we'll take a step back in history and review what happened to former high-yield darling Kinder Morgan, which owns oil and gas pipelines and related infrastructure that it leases to energy companies under long-term, fee-based contracts. Heading into 2015, Kinder Morgan was riding high. Thanks to the stable nature of its cash flow -- with more than 90% backed by fee-based contracts -- the pipeline giant expected to generate enough money to pay out $4.4 billion in dividends to investors, with $500 million to spare, which worked out to about a 90% payout ratio. Given where shares traded at the time, Kinder Morgan had a forward yield of 4.8% based on that forecast.

However, at the same time the company was paying out billions of dollars in dividends to investors, it was spending just as much to expand its pipeline empire, with the company guiding to invest $4.4 billion on expansion projects and small acquisitions that year. Under normal circumstances, Kinder Morgan would tap the debt and equity markets to raise the money it needed to fund growth. The problem was, 2015 was far from usual because oil prices were in free fall, which caused investors to cease providing capital to energy companies. That made things tough for Kinder Morgan, which already had an elevated leverage ratio (a measure of how easily a company can service its financial obligations) of 5.6 times debt to EBITDA and was on the verge of losing its investment-grade rating. Because maintaining an investment-grade credit rating was paramount to the company's operations, Kinder Morgan made the tough decision toward the end of 2015 to slash its high-yielding payout by 75% and reallocate that cash toward financing expansion projects and paying down debt.

In this case, Kinder Morgan had the stable cash flow to support its high-yield payout. However, it paid out too much of that money, which it could no longer afford to do when market conditions took a turn for the worse given its weaker credit and limited liquidity.

Image source: Getty Images.

How the tables have turned: A safe high-yield stock now worth buying

Fast-forward a few years and Kinder Morgan is on a much firmer foundation. After selling some assets, the company pushed its leverage ratio down to 5.1 times debt to EBITDA, which is comfortably within the investment-grade criteria for a pipeline company. Meanwhile, cash flow remains healthy, with the company on pace to generate $4.57 billion in DCF this year, with more than 90% supported by long-term, fee-based contracts. That's enough to pay its recently increased dividend (which now yields 4.9%) and fully fund all $2.3 billion of its planned expansion spending for the year, with more than $500 million to spare. That forecast implies that Kinder Morgan's dividend payout ratio will be around 40% this year, which is the lowest in the pipeline sector.

In other words, the Kinder Morgan of today is very different from the one a few years ago. It easily meets all three criteria, which increases the long-term sustainability of its newly increased dividend. Meanwhile, with the company allocating a large portion of its free cash flow toward expansion projects, Kinder Morgan is on pace to increase its adjusted EBITDA from $7.5 billion this year up to $9.2 billion over the next few years, which is a more-than-20% increase. As a result, the company expects to increase its dividend 25% in each of the next two years, supported by its rising income stream and a higher payout ratio, which will still be below 60% by 2020. Furthermore, the incremental earnings from those expansions should drive additional improvement in Kinder Morgan's leverage ratio, strengthening its investment-grade metrics.

That fast-growing payout, which the company backs with stable cash flow, a conservative payout ratio, and an improving balance sheet, makes Kinder Morgan an excellent high-yield stock to buy.

A safe high-yield partnership to buy

As mentioned above, some companies must pay a high-yielding dividend to remain compliant and keep their tax-advantaged status. That makes them ideal for yield-seekers. While there are several safe options among these various entities worth considering, one that stands out is Brookfield Infrastructure Partners (BIP +2.34%), which is a publicly traded partnership that's very similar to an MLP. Brookfield Infrastructure, as the name suggests, owns infrastructure assets like ports, toll roads, and electric transmission lines that generate relatively steady cash flow, enabling the company to pay a distribution that currently yields 4.9%.

Overall, Brookfield gets about 95% of its earnings from predictable sources like long-term contracts, providing the company with a solid foundation of cash flow. Meanwhile, Brookfield only pays out between 60% to 70% of its annual cash flow to support its high-yielding payout. It's worth pointing out that while partnerships like Brookfield as well as other MLPs, REITs, and BDCs need to pay out 90% of their taxable earnings, cash flow is often very different from reported earnings, which tend to be lower due to the impact of depreciation and amortization. That's why the cash flow payout ratio is less than 90% in this case. While some of these entities do choose to pay out 90% (or more) of their cash flow, the lower this number is, the better.

Finally, Brookfield has excellent financials. Its balance sheet is rock-solid and backed by a strong investment-grade credit rating. The company also has minimal near-term debt maturities and boasts ample liquidity that includes $4.2 billion of cash and borrowing capacity on its credit facility. That's more than enough of a reserve to fully fund the roughly $500 million it expects to invest in long-term expansion projects this year. Furthermore, the cash flow it retains --  approximately $200 million per year -- is more than adequate to satisfy the funding requirements of small recurring expansions on its existing assets.

Brookfield's combination of steady cash flow, a low payout ratio, and excellent financial position reduces the risk that the company will need to cut its distribution to investors. Instead, the company expects its expansion projects to help drive 6% to 9% annual cash flow growth, which should support 5% to 9% distribution growth each year. That steadily rising income stream backed by an excellent financial profile makes Brookfield Infrastructure Partners among the top high-yield stocks to buy. 

High-yield stocks don't have to be high-risk investments

The best high-yield stocks aren't those with the highest yield. Instead, they're companies that generate relatively steady cash flow, pay out a generous yet conservative portion of that money via dividends, and maintain a strong balance sheet and ample liquidity for a rainy day. Companies that share all three of those characteristics are more apt to not only safely pay a high yield but increase it over time, which should provide investors with a healthy total return over the long term.