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

December 28, 2015
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There are a number of ways one can make money in stocks.

You’ve got your swing trading, technical analysis, penny stocks, and many other avenues.

But I think one of the easiest and oldest ways to do well in stocks is also one of the best.

I’m a buy-and-hold guy who simply aims to build equity in high-quality businesses that treat shareholders right.

And I can think of no better way to treat me as a shareholder right than by sharing profit with me via dividends.

Dividends date back to the founding of the stock market.

In fact, many investors dating back a century ago bought stocks primarily for their dividends.

That was way before the days of electronic trading and access to stock quotes online.

But dividends are just as lucrative now as they ever were.

For instance, my portfolio should generate $10,000 or more in dividend income next year.

Sure, that doesn’t replace one’s salary completely.

But it sure goes a long way toward paying some bills, and I plan to use dividend income to cover all of my bills by my 40th birthday.

That’s right – financial independence before 40, all courtesy of dividend income.

Meanwhile, it’s not just dividends I’m talking about here.

I research and write about dividend growth stocks.

And I also invest my own hard-earned cash in these stocks.

These are stocks that pay dividends, sure. But they also routinely and regularly increase their dividends, meaning shareholders continually see growth in their income. The majority of the stocks I look at and invest in also grow their dividends faster than inflation, which improves shareholders’ purchasing power year in and year out.

You can see more than 700 US-listed dividend growth stocks via David Fish’s Dividend Champions, Contenders, and Challengers list, made freely and easily available to you readers right here on the site.

Mr. Fish has tirelessly collected data on every single US-listed stock that has increased its respective dividend for at least the last five consecutive years.

So if you want to invest in stocks that pay you your rightful share of profit while simultaneously regularly increasing underlying profit and the dividend that accompanies it, this list is the best resource I know of.

So I believe in buying and holding high-quality dividend growth stocks, collecting growing dividend income, and reinvesting that dividend income until the reinvesting “switch” can be turned off, allowing one to live off of growing dividend income for the rest of their life.

But that’s not all…

Quality matters. And growing dividend income is a great “litmus test” for quality.

But valuation also greatly matters.

You don’t want to just start buying random dividend growth stocks right out of the gate. That would be like walking into a store and buying random merchandise. It’s nonsensical.

Instead, you want to make sure the stock “fits” your overall investment needs and portfolio much like you’d want to make sure a shirt off the rack fits your body.

However, just as important, you also want to make sure the price is right.

How does one go about figuring that out?

Well, a great starting point would be a valuation guide that was put together by fellow contributor Dave Van Knapp. It’s specifically designed for the dividend growth stocks you’ll find on Mr. Fish’s list, so they go had in hand.

See, stocks are just like any other merchandise out there – they have a price tag, but they also have an underlying value to them, too.

The funny thing about stocks, though, is that the prices change all the time. Every second of every trading day, in fact.

But the good news is that values don’t change so rapidly. The value of a major, multinational business isn’t going to change much between Monday and Tuesday, outside of some kind of major news event.

So one simply has to value a business first, then make sure the price is as far below that value as possible so as to buy in with a margin of safety.

One might estimate the value of a stock to be $50. But paying $50 for that stock means there’s no wiggle room. What if something negative happens to the business? What if your estimate was off? What if the economy slows, taking the business’s growth prospects with it?

Instead, you want to buy in at $40, or $30, or $20.

Doing so gives you massive advantages.

All else equal, a lower price corresponds to a higher yield. Since we’re talking about dividend growth stocks here, that will almost always be a factor for you when locking in your price (and yield) when you buy.

A dividend doesn’t change with the price of a stock, but the yield sure does. Buying in cheaper means you get more passive income for the same dollar spent on stock. And that’s more income for you to compound over years and years, meaning one can start living off of dividend income even faster.

In addition, you increase the potential long-term total return.

Dividends are a major component to one’s total return. So the more yield you can generate right off the bat, the higher your potential total return over the long run.

In addition, you also capture the potential benefit of seeing the price rise back closer to its fair value, if your estimate is anywhere near correct. While the stock market tends to misprice stocks (sometimes dramatically) over the short term, it tends to be fairly accurate over the long run.

Finally, you reduce risk.

Every dollar less you have to invest for the same stock in a company is one less dollar you’re risking. That means either more shares for the same amount of money or more money for other ventures in life. Either way, it lessens your risk.

As such, you can see why I’m always interested in discovering high-quality dividend growth stocks that appear to be priced below what they’re likely worth.

This is just like finding merchandise that fits you that’s also on the clearance rack.

Well, we have one such candidate today…

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

This is one of the largest asset managers in the US, and also one of the highest quality.

In terms of size, assets under management came in at $726 billion as of the end of last quarter. Although this was down slightly compared to the previous quarter, most of the reduction came about due to market volatility. However, the lack of inflows is also notable.

In terms of quality, the vast majority of their mutual funds are beating peers both on short-term and long-term bases.

Want more evidence of quality?

The company has increased its dividend for the past 29 consecutive years.

While impressive in its own right, it’s more impressive when considering that this is an asset manager that derives fees from AUM. Of course, the broader market’s substantial correction during the financial crisis impacted fees, but T. Rowe Price kept right on delivering.

Not just a serial dividend grower, the dividend continues to grow at a rate well above inflation: The 10-year dividend growth rate stands at 16.6%.

trowWith a payout ratio of 46.2%, there’s still plenty of headroom in terms of future dividend raises.

The stock also yields 2.86% right now, which offers plenty to like for income-hungry investors.

That yield is quite a bit higher than the broader market. In addition, it’s almost 90 basis points higher than the stock’s own five-year average yield of 2%.

Lengthy track record of dividend growth? Check.

Attractive yield? Check.

Manageable payout ratio? Check.

This stock just checks off pretty much every box for me, which is a big reason I’m a shareholder.

But while the dividend and the growth of it is is imperative for me, all of that is for not if the underlying business is slowly decaying.

So we’ll check up on T. Rowe Price’s financial health and growth to see what kind of business this really is. Looking at past growth and the forecast for near-term future growth will also help us put together a reasonable estimate of fair value.

In terms of past growth, I always like to look at the prior decade. That tends to give a “big picture” of the growth story while also smoothing out temporary fluctuations and short-term macroeconomic headwinds.

Revenue grew from $1.512 billion to $3.982 billion from fiscal years 2005 to 2014. That’s a 10-year compound annual growth rate of 11.36%.

Very, very solid top-line growth here.

But the bottom line fared even better.

The company increased its earnings per share from $1.58 to $4.55 over this time frame, which is a CAGR of 12.47%.

What’s perhaps most incredible here is that the company never registered a loss during the financial crisis. Even with all the hysteria, panic, and fear that prompted mass selling of equities, T. Rowe Price stayed profitable and kept right on increasing their dividend.

You see a small divergence there between top-line and bottom-line growth, which is explained by a small reduction of the outstanding share count and a slight improvement in overall efficiency and profitability.

While it would be fantastic if T. Rowe Price could continue this kind of growth indefinitely, their AUM and the fees those assets generate for the firm are largely tied to the broader equity and bond markets.

With the domestic stock market near its all-time high, this could be a headwind. Meanwhile, rising interest rates (the Federal Reserve just increased short-term interest rates for the first time since the financial crisis) serve as a headwind for bonds.

In addition, the more secular move away from actively-managed funds and toward passive index funds serves as a potential longer-term headwind for the firm.

S&P Capital IQ predicts that T. Rowe Price will grow its EPS at a compound annual rate of 5% over the next three years, citing these headwinds. Difficult to tell if this will come to pass or not, but I wouldn’t doubt it. Nonetheless, I think this firm is well placed for the long haul. Their prowess in active funds and recent growth in retirement-date funds is why I’m a bit more enthusiastic about this firm compared to most others that focus so heavily on active management.

Further speaking to the overall quality of the firm, the balance sheet is nothing less than perfect.

They have no long-term debt, which means all of that growth was funded organically. Any firm that can grow in the low double digits without leverage earns my respect.

Profitability is also outstanding.

Over the last five years, T. Rowe Price averaged net margin of 29.24% and return on equity of 23.39%.

This firm just operates at one of the highest levels possible in its industry.

While I think there are very real risks here, especially where secular changes in the industry are concerned, the company’s overall quality, flexibility, and track record put it in an excellent spot relative to many peers.

Moreover, the valuation makes the stock particularly appealing right now…

The P/E ratio is sitting at 16.10. That’s below both the broader market (by a large degree) and the stock’s five-year average P/E ratio of 21.7. If short-term growth does really slow as much as S&P Capital IQ anticipates, a lower P/E ratio is warranted. But it’s tough to discount the firm’s more long-term prospects that much. Every other basic valuation metric (price-to-book ratio, price-to-sales ratio, etc.) is also notably below its respective recent historical average.

Cheaper than usual, but how cheap is it? What’s the stock likely worth?

I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. While it’s certainly possible near-term dividend growth could be far lower than the long-term average, the moderate payout ratio and T. Rowe Price’s penchant for rewarding shareholders gives me confidence in this model. 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.

You can play with the numbers a bit, but even a more conservative model has this stock undervalued by a large degree. The stock is a deal here unless you believe the business is permanently impaired, perhaps broken beyond repair due to moves to passive funds. But I just don’t see it. Recent AUM changes have been due to market swings rather than massive outflows. However, I’m not the only one who believes this stock is a deal.

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 4-star stock, with a fair value estimate of $83.00.

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 $81.20.

Both firms have reduced their valuations on TROW lately, but I remain confident in a more long-term view on shares. Even with the respective reductions, the stock is still quite cheap. Regardless, averaging out the three different opinions on the stock gives us a valuation of $92.17. That would indicate the stock is potentially 27% undervalued here.

trow scBottom line: T. Rowe Price Group Inc. (TROW) is a high-quality and very large US-based asset manager. Their track record through the ups and downs of the investment landscape speaks for itself, while the fundamentals across the board are fantastic. The yield is notably higher than usual while the valuation is notably lower than usual. The long-term prospects remain fairly bright, but short-term pessimism has added the possibility for 27% upside. This is an opportunity that long-term dividend growth investors should definitely take a look at right now.

– Jason Fieber, Dividend Mantra

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