I view living below your means and investing your excess cash flow into high-quality dividend growth stocks as a surefire recipe for building wealth and income, putting one in a position where they can be financially independent rather early in life.
Of course, I speak from experience on this matter.
You can see the portfolio I’ve built up by following this surefire recipe over the last six years – I’ve saved more than half my net income over that period while investing every spare penny into wonderful businesses that reward shareholders with an increasing share of their growing profit.
More importantly, that portfolio should generate five figures in dividend income this year.
And that should only grow every year for the rest of my life.
That’s because dividend growth stocks represent equity in companies that have penchants for growing their profit so regularly and routinely by selling products and/or services that people demand that they end up with more cash than they can efficiently and profitably reinvest, so they end up showering their shareholders with growing cash payments in the form of increasing dividends.
Many of these dividend growth stocks have track records of such behavior decades long, as you can see on David Fish’s Dividend Champions, Contenders, and Challengers list, which is a compilation of more than 700 such US-listed stocks.
But while this is such a great way to build wealth, income, and independence, it isn’t something that should be done without thought.
Specifically, it isn’t a good idea to buy any dividend growth stock at any price at any time.
You want to first focus on quality.
The most attractive businesses are those with a demonstrated ability to grow profit over the long run, through the good times and the bad. You want to see a reasonable amount of leverage with a flexible balance sheet. Profitability that’s competitive or, better yet, dominant. Competitive advantages like scale, pricing power, high-quality products and/or services, brand recognition, customer loyalty, and oligopolies.
Once you have a business like that in your sights, you also want to make sure you’re getting the right price.
How do you know you have the right price?
Well, the right price would be as far below a stock’s fair value as possible.
So you have two parts to that equation: price and value.
The first part, price, is a known.
Value, however, is not.
Determining the value of a company is a little bit art, a little bit science. And the best one can really do is to make a very educated and reasonable estimate, as it’s nigh impossible to ascertain a company’s intrinsic value down to the penny.
Fortunately, it’s not terribly difficult to reasonably estimate a stock’s fair value if using a methodology or system designed for that purpose.
For example, fellow contributor Dave Van Knapp discussed such a system via one of his stock lessons, and this system is specific to dividend growth stocks, making it perfect for investors interested in these stocks.
Now the reason why you want to pay as far below as your estimated fair value as possible should be obvious.
It’s clear that the less you spend on a stock, the more money you keep.
But it goes much deeper than that.
First, you introduce a margin of safety when you buy a stock far below its intrinsic fair value.
That gives you a lot of breathing room.
If you determine a stock is likely worth $100, you don’t want to pay $100.
That’s because if anything goes wrong or if your estimate was too generous, you just put your capital on the line by introducing risk.
Conversely, paying, say, $70 for that same stock gives you a lot of breathing room. It gives you a margin of safety.
Maybe your estimate was off and the stock is actually only worth $80. Maybe the company slows down. Maybe a competitor starts to eat their lunch. A lot can happen.
But only paying $70 means the intrinsic value of the company could erode quite a bit before you’d be looking at the losing end of an investment.
Moreover, it boosts your yield, increases your potential long-term total return, improves the power of dividend growth, and reduces your risk.
You can already see how risk is reduced.
But since we’re talking about dividend growth stocks here, the dividend and the growth of that dividend are paramount concerns.
All else equal, a stock’s yield will be higher when its price is lower. The two are inversely correlated.
So the less you pay, the higher the yield you receive. That’s more income in your pocket.
And since yield is a major component to total return, your potential overall long-term return from a stock is increased when you pay a lower price. That’s not even to factor in the potential upside from any repricing that might occur if/when the stock market realizes the stock is worth more than its being sold for.
In addition, dividend growth is given a big boost when paying less by virtue of seeing a pay raise (that’s determined by the company) being applied to a higher yield.
It’s just like a pay raise at a job. You’d rather get a 5% pay raise on a $50,000 salary than a 5% raise on a $40,000 salary. Although the raise is the same in either case in percentage terms, the pay increase in absolute dollar terms is far higher in the former example.
This is why I like to not just buy high-quality dividend growth stocks but buy them when they’re undervalued.
Well, I was recently looking over Mr. Fish’s list for candidates and found such a stock. This stock is also in my portfolio, so I’m currently looking at potentially increasing my stake because I do think the stock is rather undervalued right now.
Ready to know which stock it is?
United Technologies Corporation (UTX) is a diversified conglomerate that manufactures and markets a variety of products across the building systems and aerospace industries.
With all the volatility in the stock market and concern over the global economy, I find it even more important and reassuring than ever to look at companies that continued to increase their dividends through prior periods of extreme turmoil.
That’s exactly what you get here with United Technologies.
They’ve increased their dividend for the past 22 consecutive years now, and at an annual rate of 11.3% over the last decade.
The past decade, of course, included the financial crisis and ensuing Great Recession, so shareholders in this company can take a lot of solace in that.
On top of that, the stock yields 2.92% right now.
Not only is that much higher than the broader market but it’s also almost 70 basis points higher than the five-year average yield of 2.3% for the stock.
So that means more income in an investor’s pocket by buying this stock now versus what’s been available, on average, over the last five years. More income, more potential long-term total return, and greater dividend growth.
And with a payout ratio of just 39.9%, there’s still plenty of room for United Technologies to continue boosting its dividend at a very strong rate, even if underlying profit growth slows a bit over the foreseeable future.
Whereas a lot of stocks out there have somewhat high payout ratios right now due to dividend growth outstripping profit growth over the last decade, United Technologies sports a similar payout ratio to the one they had a decade ago, meaning they’ve grown at a strong rate while remaining prudent with the dividend.
Speaking of growth, let’s take a look at that.
The last decade for this company has been really impressive.
Looking at both revenue and net income changes from year to year over the last ten years, it’s almost like a major economic calamity never happened.
While there were some bumps along the way, that’s not totally unexpected since United Technologies operates in cyclical industries that are prone to changes in demand based on larger macroeconomic forces.
Revenue is up from $42.725 billion in fiscal year 2005 to $65.100 billion in FY 2014. That’s a compound annual growth rate of 4.79% over that stretch.
Not fantastic but not terrible in light of the time period in question. Moreover, what they lack in a huge growth trajectory they make up for with lower volatility in underlying results.
Due to extensive share repurchasing and expansion in margins, the profit growth on a per-share basis was far more impressive.
Earnings per share grew from $3.03 to $6.82 over this stretch, which is a CAGR of 9.43%.
I think that’s particularly solid considering that over 60% of FY 2014′s sales were international, and the strong dollar has greatly impacted their EPS results as of late.
But the outstanding share count is down by approximately 10% over the last decade, which helped propel that excess bottom-line growth and offset some of the currency effects.
That kind of activity is likely to continue, helping EPS growth in the process. That’s because the company recently sold its Sikorsky helicopter business to competitor Lockheed Martin Corporation (LMT) for $9 billion.
United Technologies has already announced that they plan on using the proceeds to buy back shares so as to offset the reduction in profit from the sale.
What’s great about this sale is that the helicopter business accounted for about 11% of their FY 2014 revenue but only 2% of the operating profit. The operating margin on this business was only 2.9% in FY 2014, which is substantially lower than the rest of the company’s units.
The sale allows United Technologies to focus on higher-margin businesses while simultaneously reducing its exposure to the US government. The US government accounted for
The core businesses that remain are the Otis elevators and escalators, Carrier HVAC products and services, Pratt & Whitney aircraft engines and gas turbines, and aerospace systems.
Looking forward, S&P Capital IQ believes United Technologies will be able to grow its EPS at a compound annual rate of 11% over the next three years, citing the Sikorsky sale, growth in air traffic, and strengthening US residential construction.
What’s incredible is that even with the drag on margins that the Sikorsky business presented, United Technologies still averaged net margin of 8.86% over the last five years. And there has been a demonstrated improvement over that time frame as well, which I think will get a big boost with Sikorsky gone.
Return on equity averaged 21.12% over the last five years, which is competitive in light of their leverage.
The long-term debt/equity ratio sits at 0.57. And the company has an interest coverage ratio of right about 9.
Both are really solid numbers, indicating no problems with leverage or interest expenses.
What you have here is just a really solid business. They’re broadly diversified across two main industries: building systems and aerospace.
Although both industries are prone to cyclical behavior, the same can be more or less said for almost any industry out there.
But until humanity figures out a way to fly without jets (and the jet engines that accompany them), aerospace should do well for a long, long time.
Meanwhile, an increasing population across the globe means more people will need to occupy the same amount of space. Studies continue to point to more people living in cities and urban environments, which means more building up (rather than out). That bodes well for systems that are designed to move people vertically. And it also bodes well for HVAC systems that will be needed to heat and cool those spaces.
With all of that considered, along with the company’s fantastic reputation for consistent dividend increases over more than two decades, one might expect to pay a premium for this stock.
But it looks like rather than a premium, the shares are available for a discount.
The stock trades hands for a P/E ratio of 13.37 right now. That’s quite low no matter how you slice it. Consider that it’s substantially lower than both the industry average and the broader market. It’s also about 18% lower than the five-year average P/E ratio of 16.3 for this stock. Every other basic valuation metric is similarly below its recent historical average, while the yield, as shown earlier, is notably above what’s usually available for this stock.
Seems to be quite cheap. What would be a reasonable estimate of the stock’s intrinsic value then? How much of a margin of safety do we have right now?
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term dividend growth rate. Although on the higher end, I think that growth rate is reasonable when considering the low payout ratio, lengthy and proven track record, and forecast for EPS growth over the foreseeable future. The DDM analysis gives me a fair value of $110.08.
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 this stock passes the two key aspects I laid out earlier: quality and value. The company is high quality across the board, and shares appear to be undervalued right now relative to intrinsic value. But if you’re looking for a second (and third) opinion to corroborate that, your wish is my command.
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 UTX as a 4-star stock, with a fair value estimate of $120.00.
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 UTX as a 4-star “buy”, with a fair value calculation of $100.10.
So I came in right in the middle there, and the average of the three figures is $110.06. That’s just two cents off from my estimate, so I think there’s a strong argument for accuracy here. Summing it up, the case that this stock is worth $110 per share is clear. That would also mean this stock is potentially 25% undervalued right now.
Bottom line: United Technologies Corporation (UTX) is a high-quality company with an incredible long-term track record of rewarding shareholders with steadily improving results and increasing dividends. Recent moves to improve the business are exciting, and the two main industries the company focuses on are likely to see tailwinds for years to come. The stock appears to offer 25% upside right now on top of a yield that’s much higher than its recent historical average. Long-term investors should strongly consider this stock at the current price.
– Jason Fieber
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