A common question we get about master limited partnerships (MLPs) is how can they pay out higher dividends than their earnings?
The answer to this question has to do with the way that depreciation and, in the case of natural resource producers, depletion expenses are treated. Depreciation and depletion expenses are a means of assigning the cost of a long-term asset, such as a pipeline or natural resource, over its useful life. These items are called "non-cash" expenses because cash is not actually being paid out for the depreciation or depletion of the long-term asset.
A corporation typically reinvests much of its cash flow to upgrade its equipment, keep pace with technological advancements, and/or expand its business. After these payments are made, the remaining cash flow can then be paid out as dividends. MLP assets, such as pipelines, however, are generally long-lived; require very little maintenance; and are not subject to major technological changes.
It is for these reasons that an MLP can pay out a very high level of its cash flow to unitholders without hurting the long-term basic earnings power of the business. This is also why investors should value MLPs based off metrics related to distributable cash flow (DCF) and not earnings.
DCF is the cash flow available to the partnership to pay distributions to LP unitholders and the GP. Since DCF strips out all non-cash items, it is a truer measure of how much cash an MLP is generating and whether it can continue to pay out or increase its dividend.
