Diamondback Energy (FANG 0.91%) is producing a gusher of free cash flow this year. The oil company is on pace to generate more than $4 billion of free cash flow, significantly more than the $2.4 billion it produced in 2021. It's returning the lion's share of that windfall to shareholders.
A large portion of that return has come through dividends. Diamondback Energy paid out $2.26 per share in dividends ($0.75 base plus $1.51 variable) during the third quarter. That gives it an implied annualized dividend yield of more than 6% at the current share price, which is several times above the S&P 500's 1.7% dividend yield. However, that dividend payment was lower than the second quarter's outlay because Diamondback chose to use more of its excess cash to repurchase stock. This decision suggests it believes its shares trade at a bargain price.
Taking advantage of the opportunity
Diamondback Energy enhanced its capital return framework earlier this year. The oil producer committed to returning at least 75% of its free cash flow to shareholders each quarter, up from its prior pledge of 50%.
The primary return comes from its base dividend, which the company has steadily increased. The oil company aims to return additional cash to shareholders through variable dividends and opportunistic share repurchases. During the second quarter, Diamondback paid $3.05 per share in dividends, consisting of a $0.75 per share base and $2.80 per share variable payment. The company also repurchased $303 million of its stock.
Diamondback shifted its capital return mix in the third quarter. It paid a lower variable dividend while boosting its share repurchases by 56% to $472 million. It has now repurchased $1.2 billion of stock this year. Diamondback's board also approved a $2 billion increase to its repurchase authorization earlier this year to $4 billion. It made that move based on its belief that the company's combination of execution, cost control and cash returns "presents a differentiated value proposition to our stockholders that is not reflected in today's equity value," according to comments by CEO Travis Stice.
A dirt-cheap oil stock
The numbers back up Diamondback's view that the market has placed a low value on the stock. The company is on track to produce over $4 billion of free cash flow this year. (Diamondback can generate $4.3 billion of cash if oil averages $80 a barrel in the fourth quarter, which is slightly above its current level). With a market cap of around $25 billion, it trades at about six times free cash flow, or a 16% free cash flow yield, which is pretty cheap:
Data source: Marathon Oil.
While it's not quite as cheap as Marathon Oil's (MRO 0.76%) bottom-of-the-barrel valuation, it's one of the least expensive oil stocks in its peer group. Diamondback's stock is also significantly cheaper than the average company in the S&P 500, given the index's 5% free cash flow yield.
That low valuation is why Diamondback Energy has such a high dividend yield. While Diamondback doesn't have the highest yield in the oil patch, it's well above the sector's roughly 4% average. It's also worth noting that Diamondback could have paid out an even higher dividend in the most recent quarter but chose to allocate that cash toward buying back its undervalued stock. Those repurchases equated to returning an additional $2.66 per share to investors in the period, more than double its total dividend outlay.
A good buy for value seekers
Diamondback Energy believes its stock is a bargain these days. That's evident in the company's decision to pay a slightly lower variable dividend in the third quarter. This decision allowed the oil company to take advantage of the opportunity to use more of its free cash to buy back its undervalued shares. Meanwhile, value-conscious investors are getting paid well while they wait for the market to realize the stock is trading near a bottom-of-the-barrel valuation.
