Undervalued Dividend Growth Stock of the Week: Royal Bank of Canada (RY)

June 21, 2015
By

What if you walked into the grocery store today and found out that your grocery bill was 20% off?

Pretty great, right?

Everyone loves a deal.

And that’s true for pretty much any merchandise in the world.

Except, it seems, for stocks.

When stocks fall, people panic.

But you should actually react in the exact opposite way.

You should be elated.

If you’re going to be buying stocks – you’re likely doing so regularly if you’re saving and investing for retirement – then you may as well buy them on sale, right?

I buy stocks almost as routinely as I buy groceries, which is exactly why I love a sale on both.

But I actually prefer a sale on stocks, and that’s because they’re not being consumed like food.

Being able to buy a stock on sale means my wealth and income can compound at a greater rate for potentially the rest of my life.

How’s that work?

Well, price and yield are inversely correlated. The cheaper a stock, the higher its yield. Assuming a company’s dividend is sustainable, nabbing the same stock at a higher yield (and cheaper price) is always preferable to the alternative (assuming the fundamentals haven’t deteriorated and caused the price to drop).

And that higher yield means more dividend dollars in my pocket for the same amount of money spent on acquiring the stock. Meanwhile, those additional dollars can be reinvested, thus buying even more stock for decades to come.

But how do we know if we’re getting a stock on sale?

Well, you have to be able to decipher the difference between price and value. If this is something that you’re unfamiliar or uncomfortable with, I recommend taking a peek at Dave Van Knapp’s essay on the subject of stock valuation.

Once you’re able to properly and reasonably value stocks, it’s just a matter of sticking to your guns and not overpaying.

This – finding high-quality stocks that are undervalued and buying them – is a strategy I’ve employed over the years to help me build a portfolio that’s well into the six figures.

The stocks I focus on buying – and those you’ll see in my portfolio – are dividend growth stocks.

And where do I find these stocks?

David Fish’s Dividend Champions, Contenders, and Challengers list is what I consider the ultimate resource for finding these stocks, as it lists more than 700 US-listed stocks that have all increased their respective dividends for at least the last five consecutive years.

Actually, it goes further than just listing the stocks; it contains valuable information like dividend growth track records, dividend growth rates, and payout ratios. Truly incredible material.

What I like to do is peruse that list and see if there are any high-quality stocks that are priced below their intrinsic value.

And I may have found one.

Royal Bank of Canada (RY) is a financial institution based in Canada, providing a variety of financial products and services to approximately 16 million personal, business, and corporate clients across 40 countries.

RY is Canada’s largest financial institution, with over CAD $1 trillion in assets.

Royal Bank of Canada operates in a very favorable regulatory and competitive market, where six major banks collectively hold approximately 90% of the country’s deposit base.

And those favorable conditions have in part allowed RY to pay out a dividend for more than 20 years, increasing their dividend for the past five consecutive years.

The reason their dividend growth track record is a little short is because they held the dividend static during the financial crisis. However, they fared much better in that respect compared to many major US financial institutions that had to cut their dividends during that tumultuous period.

But whereas the track record is a bit short, they’ve certainly made up for it in regards to growth. The five-year dividend growth rate is a rather stout 8.3%.

ryWhat perhaps makes that growth rate even more impressive is the fact that you’re getting that on top of an extremely attractive yield of 3.89%.

It’s just not often you get a yield near 4% along with a dividend growth rate in the upper single digits, especially in this low-rate environment.

The payout ratio for RY also remains quite reasonable at just 47%. So that means the company is retaining more than half its earnings to continue growing the business, while shareholders are still getting a hefty dividend.

So we definitely have a pretty solid dividend growth stock here. High yield, plenty of growth, and sustainability.

But what about growth of underlying operations?

Let’s take a look at that. I’m going to explore growth across the top and bottom lines over the last decade, which will also help us later value the business.

RY has increased its revenue from CAD $19.216 billion to CAD $34.108 billion between fiscal years 2005 to 2014. That’s a compound annual growth rate of 6.58%.

Earnings per share grew from CAD $2.57 to $6.00 over this period, which is a CAGR of 9.88%.

Really solid growth here. However, S&P Capital IQ is only anticipating 3% compound annual growth in EPS over the next three years.

As might be expected, RY maintains a very conservative balance sheet. The long-term debt/equity ratio is just 0.15 and they maintain investment-grade credit ratings of AA-/Aa3.

Profitability for Canadian banks in general is fairly robust, due in large part to the favorable environment in which they operate. RY has averaged over the last five years net interest margin of 1.89% and return on equity of 18.57% over the last five years. These numbers compare well to peers as well as the industry.

Overall, RY appears to be pretty compelling here. You’ve got that very attractive yield bolstered by excellent dividend growth. Factor in the likelihood of rising rates over the near term, and that could provide a nice tailwind for the company and its access to substantial low-cost capital.

However, that’s offset with risks ranging from regulatory concerns to a potential housing bubble developing in Canada.

But the stock isn’t worth any price. We still want a good deal, even if it’s a high-quality stock.

Are we getting a good deal here?

The stock’s P/E ratio is 12.07 right now, which is well below that of its five-year average P/E ratio of 13.6. Moreover, that’s substantially lower than the broader market.

So we might have a sale going on here. But what should we pay for RY?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 6.5% long-term dividend growth rate. That’s well below the dividend growth rate over the last five years, but it’s more in line with EPS growth over that period. I’m also factoring in a moderate payout ratio and the forecast for milder growth moving forward. But I think, when factoring in the odds of rising rates, this is probably conservative. Nonetheless, this gives me a fair value of $75.46.

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.

So my analysis indicates that this stock is indeed on sale. But I’m not the only around taking a look at RY and its valuation. Let’s compare my analysis to that of some professional analysts that track 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 RY as a 3-star stock, with a fair value estimate of $64.00.

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 RY as a 4-star “buy”, with a fair value calculation of $71.90.

The valuations vary a bit there, but I like to blend them together by averaging out the three figures so as to be able to work with one final number. And averaging the three figures out gives us $70.45. That would mean this stock is potentially 11% undervalued right now.

sc ryBottom line: Royal Bank of Canada (RY) is a high-quality bank and they’re operating in a very favorable environment where competition is limited and pricing is rational. That’s helped lead to really solid results over the last decade, which just so happens to be a period of time that includes the financial crisis. And I think even better things still yet lie ahead, especially with the odds that interest rates will rise from here. Buying RY here means you’re getting a high yield along with the potential for 11% upside.

– Jason Fieber, Dividend Mantra

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