This dividend stock blew me away

Not many firms have a dividend as high as 7.2%, and even fewer have fundamentals this strong. This dividend stock could be my new favourite.

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Windmills for electric power production.

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Building a portfolio of quality dividend stocks can be a great way to create passive income, but these can be difficult to find. Many promise high dividend yields, but have shaky fundamentals. When I find a company that ticks all the boxes, I get very excited. Here’s one that’s catching my eye.

Greencoat UK Wind

The global energy landscape is clearly moving towards a renewables-centric model. Wind power, solar power, and other technologies are steadily growing in adoption as fossil fuels decline in use.

Greencoat UK Wind (LSE:UKW) plays a large part in this transition for the UK market, with a market capitalisation of over £3bn. The firm owns a range of onshore and offshore wind farms across the UK, selling electricity to the UK’s energy providers. The share price has been fairly volatile over the last few years. Geopolitical shocks have impacted the energy sector, and enthusiasm for ESG (environmental, social, and governance) investing has sharply declined.

Growth potential

However, the appetite for renewable energy seems to be only going in one direction. Governments in most countries are pushing to expand generation capacity, and companies in the sector look well positioned to benefit.

The business expects earnings to decline over the next few years. However, I attribute that to high interest rates impacting its debt of £1.4bn. This may raise a few eyebrows, but as a regulated business, the company is bound by legislation to responsibly manage debts. As a result, I believe this will ultimately balance out. I care far more about the growth in capacity, taking share of a critical market in the coming decades.

Generous dividend

The company pays a generous dividend of 7.2%. This is clearly an appealing prospect to many investors, and is well supported by the strong balance sheet of the company. I consider this dividend to be sustainable based on the fundamentals of the business. With a payout ratio of 41% (the level of earnings paid out as dividends), I suspect there’s potential to increase further.

Valuation

Due to regulation, costs and incomes of companies in the utilities or energy sector are relatively predictable. Therefore, share prices are generally priced accurately by the market. However, a discounted cash flow calculation of the business suggests the current share price could be as much as 30% undervalued. Similarly, the price-to-earnings (P/E) ratio of 6.9 times could be far below fair value of 13.3, calculated from forecast earnings. Fund manager Stephen Lilley suggests that interest rates are the culprit for this variance, putting the renewable energy sector “under a bit of a cloud of late”.

Risks

The UK’s energy regulator OFGEM controls much of what companies can do. This means that profits may be capped, and prices are set independently. This does potentially lead to some vulnerability for the space. However, with the market moving towards renewables, the long-term trend suggests that growth should be steady, despite any volatility.

What’s next?

I think there’s a bright future ahead for companies in the sector. The fact that this dividend stock can give me some passive income along the way is a nice bonus. If management can continue to execute well, and grow share of the renewables market, then I think there could be great returns ahead. I’ll be buying at the next opportunity.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Gordon Best has no position in any of the shares mentioned. The Motley Fool UK has recommended Greencoat Uk Wind Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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