I’ve been following some recent news in the market with great interest.
One thing that has struck me as particularly interesting is some recent troubles that a prominent hedge fund manager has been experiencing.
The fund has nearly all of its money in just 11 stocks.
This lack of diversification is now coming back to bite the fund, with shares of one of its largest holdings down over 80% over the last year. Quite a few other holdings are also struggling.
But there are other lessons to be learned here.
Primarily, one should stick to high-quality companies with longstanding track records of increasing profits.
After all, we’re investing in publicly traded companies for the financial rewards.
If a company isn’t able to increase its profit like clockwork, then what are we really doing here?
And when I think of companies with incredible track records for increasing profits, I think of dividend growth stocks.
These are stocks that regularly and reliably pay and increase dividends to shareholders, which is really the ultimate “litmus test” for increasing profit.
Don’t tell me how profitable you are; show me.
More than 700 examples of these stocks can be found on David Fish’s Dividend Champions, Contenders, and Challengers list, which includes every US-listed stock with at least five consecutive years of dividend raises.
You’ll also notice that I don’t just talk the talk: I walk the walk, investing my own hard-earned cash in these stocks, building up a six-figure portfolio in the process over the last six years.
While the value of the portfolio is nice, it’s really the growing dividend income that excites me.
That dividend income should add up to more than $10,000 this year – putting me at five figures in passive income at just 33 years old.
Better yet, this income should grow faster than inflation over the long run, meaning my purchasing power increases over time.
But while sticking to high-quality dividend growth stocks is a great way to build growing wealth and income, it’s also important to buy stock when the valuation is attractive.
What I mean by that is one should aim to underpay for stock – one should buy high-quality dividend growth stocks when they’re undervalued.
An undervalued stock is one that is being sold for a price below what it’s worth.
One might think this is uncommon, but it’s really not.
Just like you can go about and find good deals (and bad deals) in your life wherever you shop, you can find good deals in the stock market.
The key, as always, is separating price from value.
While price tells you what you’re going to pay, value tells you what something is actually worth.
And you must know the latter first before deciding whether or not the price infers a good deal.
To help guide investors in determining the fair value of dividend growth stocks, fellow contributor Dave Van Knapp put together a great set of valuation tools in one resource.
You’ll want to focus on those stocks that are undervalued for a number of reasons.
First, you introduce a huge margin of safety.
Diversifying and focusing on high-quality dividend growth stocks is a great way to avoid what’s happening to this aforementioned hedge fund manager, but buying only when a stock is undervalued means you’re minimizing your downside while simultaneously maximizing your upside.
Paying $50 for a stock worth $40 means you’re adding risk and downside, with no margin of safety.
If the market realizes the overvaluation, the gap between price and value closes, taking your money with it.
But paying $30 for the same stock gives you a margin of safety.
If the company does something unexpected or something negative happens, you have breathing room there. Or what if your estimate is off a bit?
So paying far less than the estimated fair price reduces your risk.
Consider the income, too.
The dividends themselves are obviously a major part of why one buys dividend growth stocks.
Well, price and yield, all else equal, are inversely correlated.
That means paying less for a stock generally increases your yield.
See, a dividend is determined by a company’s management. It’s irrespective of a stock’s price. It’s completely reliant on a company’s ability and willingness to pay it.
For example, a company might announce a $1.00 annual dividend.
If this stock is worth $40, it yields 2.5% at fair value.
But buying in at $30 increases your yield to 3.33%.
That difference is real money in your pocket. That’s more income now and potentially for the life of the investment.
Plus, any future dividend raises will impact your income more positively as you go, meaning your aggregate income looking out over the long term could be substantially more.
Buying this stock when it’s undervalued like that could also mean your total return is greatly enhanced.
Total return is, after all, a combination of capital gain and dividends.
Well, we saw earlier how the former could be more powerful with the margin of safety.
And we see how the latter could be more powerful through the higher yield and bigger base for future dividend raises.
But I won’t leave you hanging with just that.
I’m going to put all of together for you by sharing some important information on a high-quality dividend growth stock that right now appears to be undervalued.
Visa Inc. (V) is a worldwide payments technology company that connects consumers, banks, governments, and businesses in more than 200 countries to a fast and secure electronic payments system.
Everyone knows Visa, right? The company needs no introduction.
What may need an introduction, however, is the dividend growth streak the company has amassed.
They’ve increased their dividend for eight consecutive years now.
While that may not seem impressive at first glance, keep in mind that Visa didn’t go public until 2008. So they’ve been paying a dividend and increasing for as long as they possibly could have.
And increase they have: the five-year dividend growth rate stands at an astounding 30.7%.
And thanks to a combination of starting out with a very low payout ratio (since they went public just five years ago) and strong underlying profit growth (which we’ll go over shortly), the current payout ratio is a very, very moderate 21.5%.
That means plenty of substantial dividend growth is highly likely to come for the foreseeable future.
The only potential issue here is the fact that the stock only yields 0.77% right now.
That’s about 17 basis points higher than its five-year average, but still not much there for anyone who needs income now.
This is a dividend growth stock with a big emphasis on growth.
As such, I think younger dividend growth investors with an investment horizon of decades stand to do very well here in terms of aggregate dividend income collected over the life of the investment and total return, but older investors in need of income now will likely seek out stocks offering higher yields.
And I believe the growth potential here is great, as I’ll show below.
We’ll first look at available historical top-line and bottom-line growth for the company before moving into a forecast for what may come to pass over the near future.
However, since Visa went public in 2008, I won’t be using 10-year data like I usually would, instead relying on revenue and profit numbers from fiscal year 2009 onward.
Revenue grew from $6.911 billion to $13.880 billion from FY 2009 to FY 2015. That’s a compound annual growth rate of 12.32%.
Visa increased its earnings per share from $0.51 to $2.58 over this period, which is a CAGR of 31.02%.
Truly outstanding numbers here, among the best you’ll likely find.
Looking forward, S&P Capital IQ anticipates that Visa will compound its EPS at an annual rate of 17% over the next three years. While a marked slowdown from what we see above, it’s more or less in line with growth over the last few years, which is still, obviously, quite impressive.
The recent announcement regarding Visa acquiring Visa Europe may cloud near-term results, but the long-term picture appears quite bright to me.
Another thing that’s impressive?
The balance sheet.
No long-term debt.
A company growing well into the double digits without the help of leverage is pretty tough to find. This gives Visa plenty of flexibility moving forward without the hindrance of interest expenses along the way.
Ready for more?
Over the last five years, Visa has averaged net margin of 38.20% and return on equity of 16.47%.
Visa’s business is about as scalable as it gets: more transactions don’t require much more investment or action on Visa’s part. And this business model is not capital intensive, meaning capital expenditures aren’t a large percentage of operating cash flow, leading to extremely strong cash flow and very robust profitability.
And since the vast majority of global transactions are still conducted in cash, the runway for growth (in terms of transactions) is extremely long. As the leader in electronic payments, Visa is poised to capture the lion’s share of this growth.
With all this in mind, we’d expect to pay a substantial premium for the stock.
But I’d argue the stock is actually undervalued…
The P/E ratio is sitting at 27.75. That seems rich for many stocks, but not one that’s growing like this. The five-year average is 29.9, so you can see investors today are paying a lower multiple than what’s been available, on average, over the last five years. Growing well into the double digits, the price/earnings growth ratio is sitting a bit over 1.6, which is very reasonable for a company of this caliber. Furthermore, the yield is higher now than its recent historical average.
What’s a good estimate of this stock’s fair value? Only then can we know just how undervalued it might be.
I valued shares using a dividend discount model analysis with a two-stage dividend discount model analysis to account for the low yield and high growth. I factored in a 10% discount rate. I then assumed a 20% dividend growth rate for the first 10 years, followed by an 8% terminal dividend growth rate. Very realistic numbers here, in my view, when looking at the historical dividend growth rate, low payout ratio, and underlying earnings growth. The DDM analysis gives me a fair value of $81.51.
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.
Not often I’ll say a stock with a P/E ratio over 25 looks cheap, but I think that’s the case here. Am I the only one who thinks that?
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 V as a 5-star stock, with a fair value estimate of $104.00.
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 V as a 3-star “hold”, with a fair value calculation of $61.90.
So a bit of a divergence there, which is unusual. However, that’s exactly why I like to average out these three different perspectives. You’ve got three different methodologies, so combining them into a final valuation really maximizes accuracy, in my opinion. That final valuation is $82.47, which is pretty close to what I came up with. That would then indicate this stock is potentially 12% undervalued.
Bottom line: Visa Inc. (V) is the world’s leader in digital payments. As more and more transactions move from cash to electronic payment options, Visa stands to do extremely well since it’s business is extremely scalable and its network is already largely built out. The fundamentals are about as good as you’ll ever find, and the valuation indicates possible 12% upside on top of a yield that’s higher than its recent historical average. Younger dividend growth investors with a very long-term investment horizon should strongly consider this stock here.
— Jason Fieber
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