Undervalued Dividend Growth Stock of the Week: Bank of Nova Scotia (BNS)

November 17, 2014
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yield-2-stockphotoI keep hearing about how expensive the stock market is, and how we’re ready for a crash any day now.

My crystal ball has never worked, so I can’t tell you what’s going to happen tomorrow, next week, or a month from now.

But I can tell you that I continue to find dividend growth stocks on David Fish’s Dividend Champions, Contenders, and Challengers list – a list of more than 500 US-listed stocks with at least five consecutive years of dividend raises – that are attractively priced.

What do I mean by attractively priced?

Well, you can take the price of anything – everything in the world for sale has a price tag – and make a judgement call as to whether the price lines up with the respective worth.

For instance, I remember apartment shopping years ago, before moving into the two bedroom apartment I now share with my significant other and her son.

And we saw apartments of similar size and offering similar amenities going for $1,200, $1,300, and $1,400 per month, all in the same area as where we currently live.

But the value just wasn’t there for us, so we settled on the apartment we now live in for just over $900 per month.

Now, it’s not always possible to value something down to the penny, nor is it necessary to.

But you can generally ascertain a rough idea as to what something is worth, using a variety of techniques.

Stocks can be valued as well, and David Van Knapp actually put together a nice little tutorial here on the site on stock valuation.

So I’ve been spending some time lately scanning not only David Fish’s list, but also my own portfolio for stocks priced below their intrinsic value.

And I think I may just have come across one.

Bank of Nova Scotia (BNS) is a diversified and full-service financial institution based out of Canada.

BNS doesn’t have a real lengthy track record of increasing dividends, although it also didn’t cut its dividend during the height of the financial crisis like a lot of large US banks did.

The company has been increasing its dividend for the past five consecutive years.

Over the past three years, the payout has increased at an annual rate of 7.3%.

CaptureThat growth rate isn’t bad when you consider that the stock currently yields 3.88% right now.

That’s far above the broader market, and quite a bit higher than what almost all US banks offer.

However, just keep in mind that there’s a 15% tax from the Canadian government on the dividend. In taxable accounts, this foreign dividend tax withholding should be able to be reclaimed through a US tax credit at tax time, depending on your individual circumstances.

And that hefty dividend is well-supported by earnings; the payout ratio is fairly modest, at 45.6%.

The dividend metrics look pretty solid here. You’ve got an above-average yield, with a dividend that’s growing in the high single digits. That’s a recipe for solid long-term returns.

So what about the rest of the company? We can certainly see a favorable dividend policy, but what about underlying profitability? We’ll need to know that the company can grow profits as well, or else the dividend will have to stop growing at some point. We also need to know how much the company’s growing in order to come up with a reasonable valuation.

Well, revenue has increased from C$10.184 billion in fiscal year 2004 to C$21.641 billion Canadian dollars at the end of FY 2013. That’s a compound annual growth rate of 8.72%. That’s actually rather solid, especially considering this stretch included one of the worst financial calamities of our time.

Earnings per share grew from C$2.82 to C$5.15 during this period, which is a CAGR of 6.92%. Not too shabby, especially considering the time frame and the industry being referenced.

S&P Capital IQ predicts EPS will grow at a 5% compound annual rate over the next three years. I think that is probably on the conservative side, based on guidance from the company and recent results. However, any pullback in the Canadian housing market could cause issues for domestic banking operations.

The company sports an extremely strong balance sheet. The long-term debt/equity ratio ended at 0.16 at the end of FY 2013. Meanwhile, the company’s long-term debt sports an A+ credit rating from Standard & Poors and an Aa2 rating from Moody’s.

Profitability appears robust and compares extremely well to most peers. Net margin finished at 28.67% last fiscal year, while return on equity came out to 16.37%.

The fundamentals look pretty good here. The yield is far higher than the broader market and the dividend is growing in the high single digits, while the company is growing the top line and bottom line at rather attractive rates. That’s probably why I’m a shareholder.

But while it might be a solid stock, it’s not worth just any price that’s being asked. If one is really looking for attractive long-term risk-adjusted returns, it’s imperative that a stock be purchased at fair value or better.

So what’s BNS worth here?

Let’s find out!

The stock trades hands for a price-to-earnings ratio of 11.67. That’s obviously well below the broader market, but most large banking institutions typically do trade at a discount to the market. However, BNS’s five-year average P/E ratio stands at 12.9, so it appears the stock’s price tag might be a bit cheaper than the recent historical norm.

But let’s put a number on shares so that we have a good idea of what kind of price we should pay.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term growth rate. That seems like a low hurdle, as it’s below BNS’s 10-year growth rate for both dividends and EPS. However, I always try to factor in a margin of safety with the growth rate, and I’m also considering the fact that earnings growth is expected to slow somewhat over the near term. The DDM analysis gives me a fair value of $71.81.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide. The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth. It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today. I find it to be a fairly accurate way to value dividend growth stocks.

So it would appear the stock is worth more than it’s being sold for. But what if I’m way off?

Well, let’s see what some professional analysts think of the stock here.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system. 1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value. These stars are meant to coincide with predicted returns, as a stock that is substantially overvalued will likely lead to subpar returns.

Morningstar rates BNS as a 3-star stock, with a fair value estimate of $61.00.

S&P Capital is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line. They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

S&P Capital IQ rates BNS as a 4-star “buy”, with a fair value calculation of $68.80.

Let’s average these three numbers to give us some kind of consensus. Taking all these valuations into consideration and averaging them out gives us a fair value of $67.20. Based on the fact that shares are trading at just over $60, it appears that this stock is potentially 10% undervalued right now.

scBottom line: Bank of Nova Scotia (BNS) grew at a rather robust rate right through the economic crisis, and the fundamentals across the board seem solid. It operates in what is basically an oligopoly in the Canadian banking sector, with substantial international operations as well. The yield’s highly attractive and the payout is growing at a generous rate. That’s music to a dividend growth investor’s ears. Even better, the stock appears to be trading for a 10% discount to its intrinsic value. I would definitely consider this stock here.

– Jason Fieber, Dividend Mantra

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