Undervalued Dividend Growth Stock of the Week: Eaton Vance (EV)

December 22, 2014
By

yield-stockphotoIt’s during times like now, when the stock market is volatile, that I like to comfort myself by buying the highest-quality stocks out there.

In my view, it’s tough to go wrong with stocks that have increased dividends for decades on end. After all, those dividends are paid out in cash, from cash. So a company has to increase its cash flow for decades in order to fund those dividend payments.

The stocks I routinely write about are those featured on David Fish’s Dividend Champions, Contenders, and Challengers list. The “CCC list”, as it’s referred to, compiles and tracks almost 600 US-listed stocks that have increased their dividends for at least the past five consecutive years.

As I like to say, dividends are the “proof in the pudding”.

They serve as proof that the company is increasing its profitability.

As such, you won’t find many stocks out there with forty or fifty consecutive years of annual dividend increases.

And that’s because it’s difficult to increase profitability regularly for such a long period of time.

That’s the quality proposition.

But it’s just as important to focus on the value proposition.

After all, even a high-quality stock can be a poor investment if you pay far too much for it.

And the same can be said for anything in life.

For instance, you can make an argument that a steak at a high-quality steakhouse is better than a steak you may find at your local buffet. And your argument would most likely be correct.

But if that steakhouse charges $200 for a steak, at what point does value go out the window? How good can that steak possibly taste? At $200, you’re probably just paying far too much for a great piece of meat.

It’s important to know how to value stocks. And it just so happens that you can find a solid primer on how to do so right here at the site, written by David Van Knapp.

Now, imagine finding a stock that’s both high in quality and undervalued.

I was recently reviewing the CCC list for such a potential opportunity and I found it. Even better, I’m going to share it with you readers today.

Eaton Vance Corp. (EV) is an investment management company.

Eaton Vance may fly a little under the radar, but they’ve definitely built a solid track record of rewarding shareholders with decades of increasing dividends.

EV has increased its dividend for the past 34 consecutive years, which puts it in great company.

And the dividend raises haven’t only been plentiful in quantity, but have also been rather generous in amount: Over the last 10 years, the dividend has increased by an annual rate of 15.2%.

The stock yields 2.42% right now, but that low yield is offset by the dividend growth rate.

In addition, the payout ratio, at 39.5%, is low enough to cushion any temporary setbacks in net income while still allowing the firm to continue increasing the dividend.

CaptureSo the dividend metrics across the board are really solid here.

Low payout ratio, solid yield, and great growth.

Those are some good reasons I’m considering picking this stock as an investment in my personal portfolio at some point in the very near future.

But if we want to know how much we should pay for equity in the company, we’ll have to figure out how fast they’re growing. That will give us some kind of idea as to what kind of cash flow we can expect from the company in the future, which will help with the valuation.

However, with dividend growth that strong, I’d be willing to bet that the underlying growth of the company is also very solid.

Let’s find out!

Revenue grew from $753 million at the end of fiscal year 2005 to $1.450 billion during FY 2014. That’s a compound annual growth rate of 7.55% over that 10-year stretch. I consider that a rather fantastic top-line growth rate.

Earnings per share increased from $1.13 to $2.44 during this period, which is a CAGR of 8.93%. That’s a great number when you consider this is over a decade that also included the Great Recession.

S&P Capital IQ predicts EPS will compound at a 20% annual rate over the next three years, citing improving margins and buybacks. If the company can come anywhere close to this, shareholders will likely be very happy.

The balance sheet appears solid, though room probably exists for improvement. The long-term debt/equity ratio is 0.87, while the interest coverage ratio is just over 10.

If you’re looking for strong profitability metrics, EV has your fix. Net margin is 19.59% over the last twelve months, while return on equity has averaged 42.16% over the last five years. Tough to really find anything to criticize here.

This appears to be a high-quality stock. You’ve got solid fundamentals across the board, with robust growth, excellent profitability, and a fantastic dividend track record. So it must be trading for a premium, right?

Not so fast.

The P/E ratio for EV is 16.34 right now, which is below not just the broader market, but also EV’s own five-year average P/E ratio of 21.6.

Looks good, but let’s actually value the stock to find out how much we should pay for shares.

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term growth rate. That rate is well below EV’s own long-term growth rate for both earnings and the dividend, which factors in a margin of safety. I think that’s fair. The DDM analysis gives me a fair value of $43.00.

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.

So that’s just my opinion. I think there’s value in my opinion, but I’m biased. Let’s find out what some professionals think of EV 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.

Morningstar rates EV as a 3-star stock, with a fair value estimate of $43.00.

S&P Capital IQ 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 EV as a 4-star “buy”, with a fair value calculation of $57.00.

I was right in line with Morningstar, but S&P Capital IQ is anticipating faster growth moving forward. We’ll see. Either way, you can see that EV is a solid value here, and there’s no doubt about its quality. Averaging the three numbers together gives us a fair value of $47.66. That means shares are potentially approximately 13% undervalued here, which may be a great opportunity in this volatile market.

scBottom line: Eaton Vance Corp. (EV) has increased its dividend for the past 34 consecutive years. And I anticipate plenty more years ahead. The fundamentals are solid across the board, indicating the quality of the firm. Factor in an above-average yield and great growth, and this is a wonderful stock. The fact that it may be so undervalued here is a potential opportunity that should be carefully considered. A high-quality, undervalued stock like EV may be just the answer to a volatile stock market.

– Jason Fieber, Dividend Mantra

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