I often espouse the benefits of not only buying high-quality stocks, but buying them at a discount.
A discount to what?
A stock’s value – or its intrinsic worth – should always be determined before buying.
In fact, it’s probably even a good idea to just ignore a stock’s price completely when analyzing the business. Price only tells you what you’ll pay, but value tells you what something is actually worth.
Reasonably estimating a stock’s value isn’t particularly difficult once you have the proper tools in front of you – Dave Van Knapp’s stock lesson on valuation, for instance, is handy.
Once you know the value, you know what you should pay.
What should you pay?
Less than the value you determine.
And the bigger the gap between the price you pay and what a stock is worth, the better.
That’s called a “margin of safety”.
You want that margin of safety to increase safety and reduce risk.
After all, if you pay $50 for a stock and you reasonably estimate it’s worth $50, you’re giving yourself no margin for error. If you’re wrong about even one assumption, you could be paying too much, which could also lead to capital loss and even losing money.
As such I’m always searching through David Fish’s Dividend Champions, Contenders, and Challengers list for high-quality dividend growth stocks that are priced below their intrinsic worth.
The CCC list is like the ultimate “shopping list” for buying stocks since it contains invaluable information on almost 700 US-listed stocks that have all increased their respective dividends for at least the last five consecutive years.
Fortunately, I stumbled upon a great dividend growth stock that appears to be priced well below its actual value, and I’m considering adding it to my personal portfolio over the coming weeks.
Even better, I’m going to share that name with you today.
Union Pacific Corporation (UNP) is the largest US railroad, operating more than 32,000 miles of track that serves the western two-thirds of the country.
Union Pacific is a model business for competitive advantages. The barrier to entry is about as high as it gets since it’s exceedingly unlikely that any new major rail will ever be built in the country. Thus, the major players – like UNP – already in business are very likely all there’s ever going to be.
In addition, there’s tremendous cost advantages at play for a railroad due to their extensive networks and ability to transport goods cheaper than other options, especially where no major waterway exists to connect the origin to the destination.
And UNP also has economies of scale through their network.
These advantages limit competition and allow UNP to run a very profitable enterprise. And what I particularly like about UNP is that they allow those profits to flow down to shareholders via increasing dividends.
They’ve increased their dividend for the past nine consecutive years.
The dividend growth rate over the last five years stands at a monstrous 27.3%.
Even with that massive growth in the dividend, the payout ratio still remains reasonable at 37.5%.
What’s perhaps best of all is that the yield right now, at 2.06%, is fairly attractive. It’s not often you see a yield of over 2% paired with dividend growth over 25%.
So let’s see what kind of growth UNP has managed over the last decade, which will help us value the business and reasonably estimate what we should pay.
Revenue was $13.578 billion in fiscal year 2005. That increased to $23.998 billion in FY 2014. So that’s a compound annual growth rate of 6.53%.
Earnings per share grew from $0.96 to $5.75 over this period, which is a CAGR of 22%.
We can see how they’ve managed such huge dividend growth now. A big boost in margins coupled with share reduction had a lot to do with this.
S&P Capital IQ predicts that EPS will compound at a 12% annual rate over the next three years.
UNP maintains a great balance sheet, especially considering the capital-intensive nature of the business. The long-term debt/equity ratio is 0.52 and the interest coverage ratio is just over 15.
They also generate some of the best profitability metrics in the industry. UNP has posted net margin that’s averaged 18.73% and return on equity that’s averaged 19% over the last five years. Both are outstanding as is, but they’re also improving steadily.
This is obviously a high-quality business. But is it a good deal right now?
Well, we can see that the P/E ratio is 18.20 here. That’s below the broader market, but also a bit above UNP’s own five-year average. I think we have a case of a stock that was particularly cheap before, but is less so now.
What should we pay for UNP stock?
I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. I think that rate is fair as it’s well below UNP’s own long-term average. A low payout ratio combined with strong underlying profit growth means UNP could very well continue to grow its dividend in the high single digits or low double digits for many years to come. The DDM analysis gives me a fair value of $118.80.
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.
This stock is definitely priced below its intrinsic value from where I’m standing, with a good margin of safety. But what do professional analysts think of UNP right now?
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 UNP as a 3-star stock, with a fair value estimate of $119.00.
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 UNP as a 4-star “buy”, with a fair value calculation of $122.50.
So my analysis is in line here. If we average out the three numbers so as to have one final reasonable estimate to work with, we get $120.10. That indicates that this stock is potentially 12% undervalued right now.
Bottom line: Union Pacific Corporation (UNP) is just a fantastic business with so many built-in competitive advantages that appear to be incredibly enduring. Not only that, but shares appear to be priced at a discount relative to its intrinsic worth. I’m strongly considering buying this stock myself over the coming weeks. The yield is attractive, the growth is outstanding, and it offers the potential for 12% upside. I’d recommend to take a strong look at this opportunity.
— Jason Fieber, Dividend Mantra