You might have heard the wisdom that dividend stocks with really high yields can be a trap, luring in unsuspecting investors for a juicy yield on a payout the company can't afford. Eventually, it slashes the dividend, and investors get whacked by a plummeting share price.
Shareholders of retail company Foot Locker witnessed this recently. But there are exceptions to the rule, and midstream energy company Enbridge (ENB -1.21%) seems like a prime example.
Enbridge offers investors a sizable dividend yield of almost 8% at its current price. But instead of fearing a cut, here are two reasons investors should expect those huge dividends to continue.
1. Enbridge can afford its payout with ease
First, let's discuss what Enbridge is. Oil and gas aren't everywhere; they're generally concentrated in regions with huge reserves underground. For example, the Oil Sands in Northern Canada are one of the world's largest deposit of crude oil. Enbridge is headquartered in this region.
Oil and gas must be transported to areas like the Gulf of Mexico, where it can be refined and exported. This is where midstream companies like Enbridge come in.
It owns and operates many miles of pipelines that move oil and gas to these destinations. It makes money based on how much flows through its pipes, like a tollbooth on a highway. Most of Enbridge's business is centered around pipelines moving oil and gas, but it also has a utility business and owns renewable energy assets.
The company must invest a lot of money to build its pipelines, but they produce lots of profits once they're up and running and don't require nearly as much capital for maintenance and upkeep. This makes it an excellent dividend stock.
These up-front investments can skew the company's reported profits, so it refers to a metric it calls distributable cash flow (DCF), the cash profits the business can pull out of the business.
Management forecasts the business will earn between $5.25 and $5.65 per share in DCF in 2023. Enbridge pays investors a quarterly dividend totaling $3.55 per share this year. Even if the company hits the lowest end of its guidance, its payout ratio is still just 67%, so it has plenty of money to afford its payout despite the high yield.
2. Ongoing and steady growth ahead
Ideally, Enbridge's business would grow over the long term. Profits would steadily increase, allowing management to keep raising the dividend responsibly.
Fortunately, investors could be in excellent shape here. Citing data from S&P Global, management believes that North American exports of crude oil, liquified natural gas, and renewable energy will all grow through 2035.
Image source: Enbridge.
This is important because Enbridge's business benefits the most from the volume of resources it's moving, more than commodity prices of things like oil or gas. Ongoing demand over the coming years, combined with the company's manageable payout ratio, gives the dividend solid chances of continued growth. As it is, management has already increased the dividend for 26 consecutive years.
A rock-solid dividend buy
Investors don't need a ton of stock price appreciation since Enbridge is already yielding almost 8% out of the gate. Management is targeting a long-term growth rate in the mid-single digits for its DCF, so investors could reasonably expect double-digit annual investment returns if the stock's valuation is reasonable.
If we value the stock using Enbridge's DCF per share like a typical business would use earnings per share and the price-to-earnings ratio, the stock is trading at just 6 times its 2023 guided DCF per share.
That seems like an attractive valuation if management can grow that cash flow by 5% annually. The S&P 500 trades at a multiple of 20 times its estimated 2023 profits, and traditionally grows by about 10% annually over time.
Getting half the growth rate for less than half the broader market's valuation seems like a good value, and a juicy (but well-funded) dividend only underlines Enbridge's appeal here.
