In this Dividend Growth Stock of the Month (DGSM) series, I have been presenting a variety of dividend growth companies from different economic sectors, with different yields and growth rates, to give you an idea of the breadth of the field of candidates for dividend growth investing.
This month’s selection is from the Financial sector: T. Rowe Price Group (TROW), a provider of investment advisory services to individuals and institutions.
Price’s Dividend Characteristics
Price’s dividend resume is stellar. The only chink is the low-ish yield of 2.6%. Many dividend growth investors would actually say that 2.6% is OK or even good, but I prefer stocks that yield a little more when I buy them.
By the way, the average yield of all 707 Dividend Champions, Contenders, and Challengers (CCC) is 2.8%.
But TROW makes up for its low yield with outstanding growth rates.
Its increase this March was 18%, last year’s was 16%, and its 5-year dividend growth rate (DGR) is a very good 12% per year.
For comparison, the average 5-year DGR for all Dividend Champions (companies with more than 25 straight years of increases) is 7% per year.
TROW is obviously well ahead of that pace, thus meriting the Good rating for its 5-year DGR.
T. Rowe Price’s rankings in this section are among the best that we have seen.
The company has been delivering good returns on equity (ROE) for more than 10 years. That includes the Great Recession years 2007-2009. ROE, you will recall, is a measure of a company’s efficiency in converting its assets into profits. TROW’s median operating margin of 45% is higher than that of all of its nearest competitors.
TROW’s 5-year earnings growth rate of 23% per year is excellent. Analysts estimate that its earnings growth rate going forward will be about 12% per year, which is very good.
T. Rowe Price is unusual among companies, because it operates with no debt at all. It is entirely self-funded. Therefore it has no credit rating. In Price’s industry, debt can be dangerous, as we saw during the Great Recession, when several financial firms carrying high debt had difficulty raising capital.
S&P IQ’s quality rating for TROW is A-, which S&P describes as “Above Average.”
And Morningstar awards TROW a Wide Moat rating, which is its best score. Morningstar states that asset managers tend to have inherent economic moats, based on customer switching costs and disinclination to switch. Price, which enjoys good brand recognition, has shown an ability to gather and retain investor assets during different market cycles.
If we averaged out the metrics shown in the table, awarding 5 for Excellent and 4 for Good, TROW has an average score of 4.6. That is about as good as it gets in corporations.
How Does T. Rowe Price Make Money?
As you probably know by now, I place great importance on each company’s Story. The Story describes the business model: How does the company make money, and can it continue to do so? We want to own companies with straightforward, understandable business models that are sustainable against competition and change, and that hold up well in different economic conditions.
T. Rowe Price is an asset management company. It was founded in 1937 and became publicly traded in 1986. Its customers are individuals, financial intermediaries, and institutions. It launched its first stock mutual fund in 1951, got into fixed-income funds in the 1970s, and today its products include equity, bond, and combination funds.
Price introduced its first target-date retirement funds in 2003. These funds change asset mixes automatically as clients age. Target-date funds have proved to be increasingly popular vehicles for retirement savings.
The company also manages private accounts, provides retirement advice, and offers discount brokerage and trust services.
As of the end of March, TROW had more than $773 billion in assets under management. That ranks the company as mid-sized in its field. Larger competitors include BlackRock, Blackstone Group, Bank of New York Mellon, and State Street.
TROW collects fees for its products and services. The more assets that it has under management, the higher those fees become, since they are usually based on a percentage of the assets managed.
Sometimes, TROW can grow its fees faster than assets under management. For example, its investment advisory fees grew about 15% in 2014, which was faster than its assets under management, which grew 8%.
Over the past 5 years, TROW’s target-date retirement funds have accounted for about 80% of the company’s inflows from customers. Those funds have higher fee structures than “plain” funds. Target-date funds now account for 21% of TROW’s assets under management. Price’s rather high percentage of assets in retirement accounts suggests that its products are “stickier” than many of its competitors. Customers are less likely to switch out of them, especially when they perform well.
Price’s mutual funds have been outperforming their peers; the proportion of outperforming funds is in the 73%-74% range. That helps attract new money from investors that are hungry for success and provides little incentive for existing customers to go shopping elsewhere. Of course, this can be a two-edged sword: If fund performances begin to lag competitors, investor inflows might slow or reverse.
In the past few years, TROW’s operating expenses have grown more slowly than its revenues. That has helped generate its high efficiency ratio (ROE) that we saw earlier. That kind of expense control is always a good ingredient for earnings success, and it also frees up dollars for the company to increase its dividend.
Price has a stock buyback program, but its beneficial effects are muted by its heavy use of share options as compensation and bonuses. I therefore do not award TROW any points for its buyback program.
On the 15-point scale that I use, I give T. Rowe Price 9 points for its Story.
My process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation. Let’s walk through each of the 4 steps.
FASTGraphs 1. The first step is to compare the stock’s current price to FASTGraphs’ default estimate of its fair value.
TROW’s price (black line) has been flat for about a year, so the company’s fair valuation (orange line) has been slowly rising to meet it as the company’s earnings grow. Nevertheless, the price is about 17% more than the orange fair-value line, so by this measurement, TROW is overvalued.
FASTGraphs 2. The second valuation step is to compare TROW’s price to its “normal” long-term average P/E ratio.
TROW’s valuation as actually assigned by the market (blue line) over the past 18 years has been a price-to-earnings ratio (P/E) of 22.4. TROW’s current price reflects a P/E of 17.5, which is 22% under the average fair value. So by this measure, TROW is undervalued.
Morningstar. Morningstar uses a comprehensive NPV (net present value) technique that many consider to be a superior method for valuing a stock. The idea is to calculate the current value of all the company’s future expected profits. The sum of all those profits is discounted back to the present to reflect the time value of money.
On Morningstar’s 5-star system, 3 stars indicates fair value.
Current Yield vs. Historical Yield. My final step in valuation is to compare the stock’s current yield to its historical yield. It is better to be near the top of that range instead of the bottom.
I normally use a Ychart to illustrate a stock’s historical yield, but Ycharts at the moment seems to have a data error, because it shows TROW’s current yield as 4.2% instead of the correct 2.6%. So instead I present here a snapshot from Morningstar’s Valuation page. The 5th line down presents the dividend yield, and in the far right column you can see TROW’s 5-year average dividend yield is 2.0%.
The current indicated yield of 2.6% is far above the 5-year average yield. That suggests that TROW is undervalued.
Note: The yield shown in the second column, 2.3%, is TROW’s backwards-looking yield. I always use the stock’s forward-looking yield, which is calculated by annualizing its latest regular dividend. That yield is 2.6%. This screen shot from Morningstar shows the two yield calculations.
It also shows that TROW paid a “special dividend” in April. Special dividends are ignored when examining a stock’s dividend payout history and in calculating its yield, because they are not regular events. It is probably the special dividend that threw off Ychart’s yield calculation.
Valuation Summary:As shown in the last line of the table, I consider T. Rowe Price to be a little better than fairly valued at this time.
There are a couple of factors that I like to look at that do not fall neatly into any of the earlier categories.
Beta measures a stock’s price volatility relative to the market as a whole. Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them.
TROW’s beta, at 1.4, is 40% higher than the market’s beta. That means that its price tends to be more volatile than the market.
This would be a mark against the stock for most dividend growth investors. If past is prologue, you can expect to see weekly and monthly price swings that are more than the market’s and that you may find upsetting. An investor’s ability and willingness to be OK with price volatility is often called risk tolerance. Whether you want to own a stock with high price volatility is a question that only you can answer.
The second miscellaneous factor is analysts’ recommendations. Most analysts are mainly interested in short-term price changes rather than dividend growth.
Nevertheless, I like to see what the consensus ratings are. As you can see, per the most recent S&P Capital IQ report, 20 analysts cover TROW, and overall they score it 3.75 on a 5-point scale. 1 = Strong Sell and 5 = Strong Buy, so a rating just under 4 means that the consensus is just under Buy.
T. Rowe Price is an intriguing stock. Let’s do a summary of the pro-and-con factors. The pros are:
• TROW is a very high-quality company.
• It is a Dividend Champion.
• It has a fast dividend growth rate.
• Estimates are for continued business success and healthy earnings growth.
• It is fairly valued.
Bears would say:
• Its yield is a little low at 2.6%.
• Its price tends to be volatile.
Personally, I like to purchase stocks when they have yields of 2.7% or more, so TROW is just below that. Because of its price volatility, I would like to have a margin of safety above my usual yield requirement. So if its yield were to rise to around 3%, I would be willing to add it to my own portfolio.
Many investors would say that with its stellar quality marks and fast dividend growth history, TROW would be fine to buy right now.
— Dave Van Knapp
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