Undervalued Dividend Growth Stock of the Week: Eaton Vance Corp. (EV)

Every stock must be expensive right now. Right?

After all, the S&P 500 is up more than 90% over just the last five years.

But what does that really tell us?

If something that’s worth $50 was at one point priced at $25, but doubles in price over a period of time and is repriced back near $50, does that doubling in price mean it’s now expensive?

No. It just means that it was an incredible value before and is now priced appropriately.

And that’s kind of what’s happened with stocks over the last five years.

In general terms, the market was pretty cheap a few years ago. Now it’s not.

And that’s why it’s so important to separate price and value.

Price only tells you how much something costs.

It tells you what you’ll pay.

But value tells you what something is actually worth.

It tells you what you’re getting for your money.

In addition, it’s important to think about the market for what it is – a big basket of individual stocks.

The stock market is like a store where a lot of merchandise is up for sale. But what the store is priced at, in aggregate, doesn’t necessarily tell you a lot about one piece of merchandise.

So what I like to do is look at individual opportunities within the market, especially high-quality dividend growth stocks that are priced less than what they’re worth.

These dividend growth stocks that I like to look at – and purchase for my personal portfolio – can be largely found on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish’s list is a dynamic and robust, featuring an updated list of more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years.

The reason I focus on these stocks is because I’m aiming to live off of the growing dividend income my portfolio generates. And I want to be able to do that – and become financially independent in the process – by the time I’m 40 which is just seven years from now.

With many companies increasing their respective dividends for decades on end for their shareholders, that’s the kind of peace and mind I can count on when it comes time to live off of passive dividend income and go about my life, not needing to worry about the day-to-day movements of the stock market.

But while these stocks are attractive by their very nature, it’s important also to look at value.

And that’s because you give yourself the possibility of greater returns and income while at the same time reducing risk.

If I see a stock that’s priced at $50 and it pays a $1.00 annual dividend per share, that’s a yield of 2%.

But what if this stock is only worth $40? At that price, it yields 2.50%, which is an improvement of 50 basis points. And that spread can make a big difference when compounded out over decades.

So why would I pay $50 and put $10 capital at risk while also accepting less income? Doesn’t make sense, right?

That’s why I love to pay fair value or less.

If valuing stocks is something you’re not familiar or comfortable with, it’d be in your best interest to learn a system that works for you. Dave Van Knapp has shared his system before, and it’s a great place to start.

I was recently perusing Mr. Fish’s list for an investment candidate that showed quality and acceptable valuation.

And I may just have found an excellent idea in the process.

Eaton Vance Corp. (EV), along with its subsidiaries, provides investment management and advisory services to individual and institutional investors.

Not a household name, but that doesn’t make it any less of a compelling investment idea right now.

With more than $307 billion in total assets under management as of the end of June 2015, they’re one of the largest asset managers in the US. Asset managers tend to have a certain “stickiness” to them, as investors tend to stick with a firm as long as objectives are being met.

That advantage has allowed the company to excel. And they’re definitely not keeping all that success to themselves, sharing growing profit with shareholders in the form of an increasing dividend. Eaton Vance has increased its dividend for the past 34 consecutive years.

But it’s not just the time frame that’s impressive. The amount by which the dividend is increasing is also astounding. With a 10-year dividend growth rate of 12.7%, shareholders’ purchasing power is increasing year in and year out.

EVThe yield is also fairly attractive right now at 2.55%.

And that yield is backed by a healthy payout ratio of 47.6%.

That means there’s still plenty of room for future dividend increases, which bodes well for shareholders.

With double-digit dividend growth and a modest payout ratio, one would expect that the company has grown underlying profit at a healthy rate over the last decade.

Well, you’d be right…

Revenue has grown from $753 million to $1.450 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 7.55%.

Meanwhile, earnings per share increased from $1.13 to $2.44 over that time frame, which is a CAGR of 8.93%.

Not much to dislike here. High-single-digit growth in profit per share is always a welcome site.

And it doesn’t appear to be a party that’s ending, either. Recent growth hasn’t slowed, while S&P Capital IQ anticipates EPS to compound at a 10% annual rate over the next three years, citing the belief that AUM will continue to grow at a robust rate.

The rest of the fundamentals are also high quality, though I think the balance sheet could improve.

The long-term debt/equity ratio is 0.87. And the interest coverage ratio is over 17. Solid numbers, though many of the major domestic asset managers have better balance sheets.

Profitability is also solid. Over the last five years, the company has generated net margin of 16.94% and return on equity of 41.63%.

I think the firm is in a great spot. The country has great need for additional investment as reports continue to show that people don’t save and invest enough. Any positive changes here serve as an additional tailwind. Meanwhile, AUM continues to grow from net inflows regularly.

However, any major decline in equity or fixed income markets could reduce AUM, so that’s a risk that should be carefully considered, especially with markets being where they’re at.

The quality is there. But is the stock a good deal right now?

The current P/E ratio on this stock is 18.62. That’s a discount to both the broader market and EV’s five-year average of 20. That seems more than fair here when considering the quality and growth.

Appears to be undervalued, but what’s it really worth?

I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 7.5%. That growth rate seems appropriate here. The company’s modest payout ratio, historical growth, forecast for growth moving forward, and recent dividend raises all portend that there’s a margin of safety in that assumption. The DDM analysis gives me a fair value of $43.00.

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.

I believe we have an undervalued stock here, and one that’s fairly high quality. But my opinion isn’t the only one out there. Let’s compare my analysis to that of some of the professional analysts that track 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 EV as a 3-star stock, with a fair value estimate of $43.00.

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 EV as a 4-star “buy”, with a fair value calculation of $53.90.

So I’m definitely not alone here. I’m right in line with Morningstar there, which seems accurate to me. But averaging out the three numbers so as to have one final number to work with, we get $46.63. That would mean this stock is quite possibly 19% undervalued right now.

sc EVBottom line: Eaton Vance Corp. (EV) is one of the largest domestic asset managers, with growing AUM due to both rising markets and net inflows. The fundamentals are solid across the board and the dividend growth track record is nothing less than incredible. The company appears poised to continue growing, and the stock offers the potential for 19% upside. This is a pretty compelling opportunity right now that should be strongly considered.

— Jason Fieber, Dividend Mantra

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