Should You Buy the Third-Highest Yielding Stock in the Dow Jones Industrial Average?

The Dow Jones Industrial Average is known for its 30 blue chip components that act as representatives of the broader market. All but two components ( Amazon and Boeing ) pay dividends -- but many of these stocks have low yields.

With a 4.2% yield, Chevron (NYSE: CVX) is the third-highest yielding stock in the Dow. Here's why Chevron is a well-rounded company with a path toward growing its payout for years to come -- making it a good addition to investors' portfolios.

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The recipe for a reliable dividend-paying energy stock

Chevron has paid and raised its dividend for 37 consecutive years , an impressive feat for a company that operates in a highly cyclical industry. But there are some years where it loses money and has to rely on cash from its balance sheet or debt to pay the dividend.

CVX EPS Diluted (TTM) data by YCharts

In the chart, you'll notice that Chevron lost money after the 2015 oil and gas crash and the COVID-19-induced downturn. However, there have been years of outsize gains, where earnings per share (EPS) doubled or even tripled the dividend payment. To offset this volatility, Chevron has stayed disciplined and maintained a healthy balance sheet to endure downturns while not overspending during expansion periods.

The most consistent dividend-paying companies are able to gradually raise their earnings while keeping their payout ratios in check. The payout ratio is simply dividends per share divided by EPS. A payout ratio of 50% is generally considered healthy , but a 75% payout ratio is fine if the company is financially strong. Chevron's payout ratio can swing wildly, but it currently sits at 56.6% -- which is good, especially considering Chevron's balance sheet is in impeccable shape.

CVX Net Total Long Term Debt (Quarterly) data by YCharts

Chevron has very little debt on its balance sheet for a company of its size -- hence the low debt-to-capital and financial debt-to-equity ratios. These metrics can be useful to gauge a company's debt relative to its size rather than looking at debt as stand-alone figure. Low leverage gives Chevron the wiggle room needed to take on debt if there's a prolonged downturn without jeopardizing the financial health of the business.

Chevron is prepared for lower oil prices

Chevron has a clear path toward growing earnings and free cash flow (FCF) over the medium term. In its June investor presentation, Chevron said it expects to sustain a return on capital employed (ROCE) above 12% through 2027 and 10% average annual FCF growth through 2027. The estimates are based on $60-per-barrel Brent crude oil prices. For context, Brent crude oil prices are currently above $80 per barrel.

ROCE is an important profitability metric, especially for capital-intensive businesses . ROCE is earnings before interest and taxes divided by total assets minus current liabilities. It shows a company's ability to manage debt and earn profit from its capital. FCF is also important because it can be used to pay dividends, buy back stock, or finance other activities.

Chevron outlined two scenarios for the five years from 2023 to 2027. The first is for $60 Brent prices, resulting in about $10 billion in buybacks per year or 3% of Chevron's outstanding shares per year. The second scenario is for $85 average Brent prices, resulting in $20 billion in buybacks per year -- or 6% of Chevron's outstanding share count per year. In the $60 Brent scenario, Chevron leans on debt and cash on its balance sheet to make buybacks. However, the key takeaway is that it still has a cushion to buy back stock even at a lower crude oil price.

Chevron has estimated that it can still fund its dividend and capital expenditures at $50-per-barrel of Brent oil. At that price, it would probably pause buybacks. At a price below $50, Chevron could pull back capex like it did during the pandemic. Still, Chevron's ability to generate solid returns even at lower prices is a testament to the efficiency of its business. It also shows how much the company prioritized steady dividend raises -- even during downturns.

By comparison, more levered-up exploration and production companies don't have the margin for error to adjust during a downturn. They can generate massive profits if oil prices stay high but are more vulnerable to losses and dividend cuts during downturns.

Chevron has upside potential and downside protection

A dividend is only as good as the business paying it. Chevron not only has a high yield, but it also has a long track record of paying and raising its dividend even during periods of low oil prices.

Chevron has a clear path toward earnings and FCF growth as it invests in new opportunities with a low cost of production. Its capital expenditure budget includes low carbon investments, as Chevron has spent billions over the last few years investing in carbon capture, utilization, and storage, hydrogen, biofuels, and other ways to diversify its portfolio away from purely oil and gas.

The company can still deliver value to shareholders even if oil prices fall 25%. But if oil prices hold up around where they are, Chevron could reduce its share count by a staggering 30% in just five years. That's an unheard-of pace for a company this size.

In sum, Chevron stands out as one of the safest ways to invest in the oil and gas industry and could be a particularly compelling buy if you're looking to boost your passive income team.

John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon and Chevron. The Motley Fool has a disclosure policy .