Undervalued Dividend Growth Stock of the Week: T. Rowe Price (TROW)

Price and value.

People might assume they’re one and the same, but they’re most certainly not.

This is apparent in all aspects of life.

For instance, you might see a pair of blue jeans priced at $70 at your local department store.

Then, the very next day, a sale hits and the same pair of jeans is now priced at $40.

Did the value change?

No. It’s still the same article of clothing it was yesterday.

The jeans aren’t all of the sudden worth less; they’re just priced lower.

You can assume that the jeans were overpriced $70, but hindsight is 20/20.

And that’s what’s so interesting about the stock market.

Every day, you see prices go up and down, sometimes for seemingly no reason at all.

Are the values of major businesses really changing that much every minute of every trading day?

No. It’s not like a $300 billion company is worth a billion more or less on Tuesday compared to Monday when nothing changed with the underlying business.

This is why it’s important to separate price and value.

Stock represents equity ownership in real businesses, and so it’s important to realize that there’s a way to value that equity ownership.

If you’re unsure how to go about doing that, it’s worth your time to check out this valuation primer written by prominent investor and writer Dave Van Knapp.

You want to be the smart shopper that picks that pair of jeans up at $40, not $70. Likewise, you want to be the smart investor that pays $40 for a stock worth $70.

Paying less than fair value for a stock means you not only reduce risk by limiting the potential for losses, but you also likely increase your overall long-term wealth and income potential.

And that’s because a stock’s price and its yield are inversely correlated; the less you pay, the higher the yield. A higher yield means more money in your pocket now as well as the ability to reinvest at a higher rate over the long run.

This is why I’m so adamant about finding good deals when adding stocks to my own personal portfolio. I believe this adamant stance has helped me largely avoid overpaying for stocks, which has in turn allowed me to build the portfolio up to almost $200,000 in market value.

But I don’t look for deals on just any stocks.

I look for deals on dividend growth stocks.

These stocks are what you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list. It’s an invaluable document that contains information on more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years.

With that said, I see a stock on Mr. Fish’s list right now that not only exudes quality across the board, but also appears to be “on sale”.

T. Rowe Price Group Inc. (TROW) is a global investment manager that provides asset management services for institutional and individual investors.

This company might fly under the radar, but I’d argue it really shouldn’t. If you’re looking for strong current income as well as exceptional dividend growth, TROW offers a compelling case.

trowFor starters, they’ve increased their dividend for the past 29 consecutive years.

But it gets better: The 10-year dividend growth rate is a stout 16.6%.

Take that, inflation!

Just imagine how much your purchasing power increases when your income is increasing at a rate in the high double digits, while inflation is in the very low single digits.

Even with that high dividend growth rate, the payout ratio still remains reasonable at 46.6%. That means the company is sending out less than half its earnings in the form of a dividend, keeping the other 53.4% of EPS to continue growing the company.

And the yield is actually quite attractive here. At 2.63%, that’s substantially higher than the stock’s five-year average of just 2%. In addition, that’s more than 60 basis points higher than the broader market.

So you’re getting a rather attractive yield backed by extremely strong dividend growth. Not much to dislike here.

But what about underlying growth? Without a growing company the dividend will eventually stop growing as well.

Let’s take a look at what kind of growth the company has managed over the last decade, which will help us determine both the resiliency of the dividend as well as the reasonable value of the company.

TROW has increased its revenue from $1.512 billion in fiscal year 2005 to $3.982 billion in FY 2014. That’s a compound annual growth rate of 11.36%. Impressive top-line growth here.

Meanwhile, EPS is up from $1.58 to $4.55 over this period, which is a CAGR of 12.47%. Again, very impressive.

S&P Capital IQ predicts that EPS will compound at a 5% annual rate over the next three years, citing the possibility of slowing growth for assets under management after strong performance in equity and fixed-income markets over the last five years.

It’s certainly plausible growth slows over the short term, but the company’s track record speaks for itself. Keep in mind as well that the above growth stretches right through the financial crisis and ensuing Great Recession. If they can grow like that through a very unfavorable period, it stands to reason they’ll do well without those headwinds.

One other aspect of TROW that I really like is that the balance sheet is completely flawless. The company has no long-term debt at all. Imagine that: They’ve grown as fast as they have through a financial crisis and without any leverage. That’s pretty incredible, in my view.

Profitability across the board is also fantastic and near or at the top of the industry. Net margin has averaged 29.24% and return on equity has averaged 23.39% over the last five years. Exceptional.

Growing dividend? Check. Excellent fundamentals? Check. Above-average yield? Check. Solid growth across revenue and EPS? Check. We even get a spotless balance sheet. Check.

So the quality is obvious here. But is the market valuing that quality appropriately? Or do we have a deal on our hands?

TROW sports a P/E ratio of 17.73 right now. That’s substantially below the five-year average P/E ratio of 21.6 for this stock. That’s also well below the broader market.

It seems we might have a sale on our hands. But what’s the price we should pay? What’s the value of TROW?

I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term growth rate. That growth rate is about half that of what TROW has generated over the last decade and also well below that of underlying earnings growth. Furthermore, the payout ratio is quite healthy. However, the possibility of a pullback in the broader market – which would bring down AUM – means that margin of safety is warranted. The DDM analysis gives me a fair value of $112.32.

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.

Maybe I’m way off, though? Maybe this stock isn’t that cheap? Let’s compare my result with that of some professional analysts that follow, analyze, and value this stock.

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 TROW as a 3-star stock, with a fair value estimate of $89.00.

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 TROW as a 4-star “buy”, with a fair value calculation of $97.60.

Looks like I’m definitely not alone here, though I came in a bit high. But I like to average out the three valuations so as to come to one, conclusive figure for you readers. That average is $99.64. That would indicate that this stock is potentially 26% undervalued right now.

sc TROWBottom line: T. Rowe Price Group Inc. (TROW) is a high-quality asset manager with robust growth, a debt-free balance sheet, attractive yield, and a track record for rewarding shareholders with an increasing dividend. The company is doing incredibly well across the board, yet the market has marked down shares and put them on sale. The price clearly seems to be below what the stock is worth, providing a great opportunity to buy in here. Even better, shares go ex-dividend next week. I’d strongly consider this stock right now.

— Jason Fieber, Dividend Mantra

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