If you’re looking to build wealth and growing passive income, it’s tough to find a better strategy than that of investing in high-quality dividend growth stocks.
These are stocks that represent equity in businesses that are generally so good at routinely increasing their profit that they simply end up with too much money.
A good problem to have, right?
So that excess profit – profit that can’t be used to efficiently and/or effectively organically grow the business – is sent to the shareholders in the form of a dividend.
And these dividend growth stocks don’t just pay a dividend, but increase their respective dividends year after year.
You’ll find more than 700 such examples on David Fish’s Dividend Champions, Contenders, and Challengers list.
While investing in these kinds of stocks is a great strategy at its core, you also have to be very mindful of what you pay for stock. And that’s true for even the best businesses in the world.
You can pull up any stock quote during normal market hours and get a price right there on the spot. Good stuff. You know what you’d have to pay for a share in any publicly traded company.
But what does that really tell you?
I’d argue not much of all.
Value is what you really want to know. You want to know what something is worth, not what it’s being sold for.
If something is worth $40 but it’s price at $50, how well are you going to do there? And how well are you going to do if you constantly overpay for everything in life?
Not very well.
This is exactly why I’m always on the hunt for high-quality stocks that are priced at or below their intrinsic value.
While I can pull up the price of any stock, determining a reasonable estimate as to its fair value is a bit more difficult. But fear not, as this handy little guide on valuating dividend growth stocks, published by Dave Van Knapp, helps the process along.
Buying a high-quality stock for less than its worth means I’m introducing a margin of safety in case my assumptions are incorrect. And that margin of safety also helps with the upside, as buying in below fair value increases the odds that I’ll see short-term and long-term capital gains, as the market recognizes that value over time.
Not only that, but my yield will also be higher than what it would have been if I otherwise overpaid. And that’s because price and yield are inversely correlated.
So you can see why I’m always interested in adding high-quality dividend growth stocks to my personal portfolio that are fairly valued or better.
And I may have found one. But I’m not greedy. I’m going to share that stock with you readers!
Norfolk Southern Corp. (NSC) transports raw materials, intermediate products, and finished goods across the Eastern, Southeastern, and Midwest United States via approximately 21,000 miles of rail, and via interchange with rail carriers, to the rest of the US. They are a Class I railroad.
I truly love the railroads. The competitive advantages are huge and they’re built right in.
When’s the last time you heard of a major rail line being erected across the US? When’s the last time a railroad company started up?
That’s right. All the major rail that currently exists in the US is probably all that ever will exist due to the difficulties in securing new rights of way across an increasingly inhabited country. Thus, the competitive advantages are enormous for those railroads that are already in existence, like Norfolk Southern.
That’s not even to speak of the economies of scale and costs advantages of moving certain goods across rail.
Those built-in advantages have in part led to NSC’s ability to increase its dividend for the past 14 consecutive years.
And the rate at which the dividend has increased is truly impressive – the company has increased that dividend by an annual clip of 20% over the last decade. That dividend is moving in the right direction, almost as fast as a locomotive.
Now, that kind of growth will sometimes lead to a stretched payout ratio and difficulties regarding increasing the dividend moving forward. Yet NSC still maintains a low payout ratio of just 37.9%.
In addition, the yield is a market-beating 2.43%.
What’s not to like there with the dividend?
So let’s see what NSC has managed in terms of growth over the last decade.
Looking at growth will tell us a lot about where they’ve been, where they might be going, and how much this business is approximately worth.
Revenue was $8.527 billion in fiscal year 2005. That increased to $11.624 billion in FY 2014. That’s a compound annual growth rate of 3.5%.
Meanwhile, earnings per share is up from $3.11 to $6.39 over this time frame, which is a CAGR of 8.33%. The extra bottom-line growth was fueled largely by significant share buybacks – NSC has reduced its outstanding shares by about 24% during this stretch.
Pretty solid growth there over the last decade. S&P Capital IQ is predicting that NSC’s EPS will compound at a 10% annual rate over the next three years, on the back of improving margins and greater efficiency.
Like most railroads and other capital-intensive businesses, NSC does have sizable debt on the books. However, a long-term debt/equity ratio of 0.72 and interest coverage ratio of 6.63 indicates no issues at all. They have a balance sheet quite similar to their major competitor along the East Coast in CSX Corporation (CSX).
High-quality business across the board. Railroads have been around since the early 1800s and continue to be massively profitable enterprises. I see no reason that won’t continue. As long as goods need to be cheaply transported across great distances, railroads will be around and doing well.
And those built-in advantages means the existing railroads are unlikely to face new competition anytime soon.
But even high-quality businesses aren’t worth paying too much for. Is NSC a good deal here?
The P/E ratio on this stock is 15.57 right now. That’s more or less in line with its own five-year average ratio, but also significantly less than the P/E ratio of 20.71 that the S&P 500 index is trading for.
We could have an opportunity on our hands for a high-quality business trading at a fair price in an otherwise expensive market. Let’s see what this stock is actually worth, though.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term dividend growth rate. That’s well below the rate at which underlying profit and the dividend have both grown over the last decade, and also well below the forecast for EPS growth moving forward. In addition, the railroad has a low payout ratio. The DDM analysis gives me a fair value of $101.48.
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.
Looks like we might have a candidate here, as my analysis concludes that the stock is mildly undervalued. But let’s see what some of the professional analysts that follow this stock think about the stock’s valuation.
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 NSC as a 3-star stock, with a fair value estimate of $108.00.
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 NSC as a 4-star “buy”, with a fair value calculation of $119.90.
I came in pretty conservative here, but you can see the trend. Averaging out the three numbers so as to have one final number to work off of, we get $109.79. That’s 13% above where the stock is trading at right now, indicating the possibility of double-digit undervaluation. NSC is down over 11% YTD, so it would appear there’s a window of opportunity right now.
Bottom line: Norfolk Southern Corp. (NSC) is one of the largest railroads in the country, serving vital ports along the Eastern seaboard. Built-in competitive advantages means the odds that they’ll continue running profitability for years to come are high. 14 consecutive years of dividend growth at a very high rate is quite appealing. Meanwhile, the stock appears undervalued here, with the potential for 13% upside on top of a market-beating yield. I’d strongly consider this stock right now.
— Jason Fieber, Dividend Mantra