I’ve heard so many people over the years state that buying stocks is akin to jetting off to Las Vegas and gambling your money away.
That’s a shame that those people believe that, because they’re just plain wrong.
The broader stock market has compounded at something like 9% annually over the last 100 years.
Consider, then, compounding a $1,000 investment (with no further additions) at 9% annually for 30 years will turn it into almost $15,000 (ignoring inflation and taxes) – that’s almost 15 times your initial investment!
If that’s gambling, sign me up.
Well, I’ve actually already signed up…
I now control a portfolio worth almost $300,000 at just 33 years old.
And I can tell you that I’ve seen compounding work firsthand – I’ve invested far less than $300,000 of my own money, meaning the rest is compounding working for me.
More importantly, this portfolio should spit out well over $10,000 in dividend income this year, which, due to my frugal nature, covers a rather significant percentage of my expenses.
But what about inflation?
Got it covered, folks.
I invest in high-quality dividend growth stocks.
These are stocks that not only regularly and reliably pay dividends but also increase them almost like clockwork year in and year out.
And these dividend increases tend to outpace inflation. So my purchasing power is actually likely to increase rather than decrease over time.
You can find more than 700 examples of dividend growth stocks by perusing David Fish’s Dividend Champions, Contenders, and Challengers list, a fantastic compilation of all US-listed stocks with at least five consecutive years of dividend increases.
An increasing dividend is about as surefire a sign that a business is doing well as any. And it’s certainly a sign of a well-run business. Cash doesn’t lie, and larger cash payments to shareholders means bigger profits must be there to support that behavior.
However, this isn’t a strategy to follow blindly where one just buys random dividend growth stocks at random prices.
It’s important to be mindful of the price you’re paying within the context of what a stock is actually worth, avoiding stocks when they’re overpriced.
Said another way, you want to buy a high-quality dividend growth stock when it’s undervalued.
See, price tells you nothing more than how much money you have to pay for a stock.
Value, meanwhile, tells you everything else. Value tells you how much a stock is worth. Value gives context to price. Value tells you what you’re getting for your money.
Buying a dividend growth stock when it’s undervalued is an attractive proposition for a variety of reasons.
You’ll likely be locking in a higher yield, better potential long-term total return, more aggregate income over the life of your investment, and less risk.
Since price and yield are inversely correlated, a lower price will almost always equal a higher yield (sans some dividend change at the company level).
And a higher yield is more income in your pocket.
Moreover, all the future dividend increases you’re entitled to will be based off of that higher yield, meaning more income in absolute terms even as the dividend increases in percentage terms are no different.
Of course, this also has a positive impact on your potential long-term total return since one component, yield, is higher right off the bat. And we can also see how total income, in aggregate, should be higher when buying an undervalued dividend growth stock (when compared to paying more).
Meanwhile, the other component to total return, capital gain, is also positively impacted when paying far below fair value.
It’s like a spring. If a stock is worth $50, the farther below that price you pay, the higher the potential upside.
On top of all that, you reduce your risk when paying less.
Paying $75 for a stock worth $50 risks that extra $25 per share that you overpaid by; you’re risking the odds that the collective stock market realizes the mispricing that’s occurred, repricing that stock closer to what it’s worth, evaporating your capital in the process.
The reverse is also true when you buy an undervalued stock. Except it’s upside rather than downside.
Good news, though.
The Internet is wonderful for many reasons, not least of which for the sheer number of resources out there designed to help long-term investors estimate the fair value of stocks.
One such valuation resource is freely available here on the site.
Put together by fellow contributor Dave Van Knapp, it’s one of his “dividend growth investing lessons”, and it’s really worth a read.
In light of all of this, I’m always on the lookout for a great dividend growth stock that appears to be selling for less than what it’s really worth.
And I may just have found one…
Principal Financial Group Inc. (PFG) is a financial services company that offers a broad range of products and services, including asset management and insurance.
This is a company with roots dating back to the late 1800s. Due to their corporate history, they’ve operated through the Great Depression; however, they went public (after an IPO) in 2001.
Principal has long focused on mutual life insurance. But they’ve branched out into other financial services, which has led to a rather diversified business model.
They now manage approximately $540 billion in assets, making them one of the world’s largest asset managers. Principal tends to go after smaller businesses, which they believe is underserved by larger players. And since they manage pension and retirement accounts, these assets (and customers) tend to be quite sticky.
Now, one knock against Principal is that they’ve only increased their dividend for the past six consecutive years.
The track record is so short because the company cut the dividend during the financial crisis.
Of course, the financial crisis and ensuing Great Recession is likely a generational event, and it’s an event that swallowed some major firms whole. Principal, meanwhile, remained quite profitable through the crisis.
And they’ve certainly made up a lot of ground: the five-year dividend growth rate stands at 22.2%.
That kind of dividend growth is highly unlikely to continue, as much of that was powered by an expansion of the payout ratio coming off of the dividend cut. For instance, the most recent dividend increase was just over 5.5%.
But underlying growth has also been strong during this period, leading to a still-low payout ratio of just 37.4%.
So even with supercharged dividend growth, the payout ratio still allows for plenty of sizable dividend raises moving forward.
While that’s appealing already, it’s made even more so when considering the stock yields 3.86% right now.
A yield near 4% is awfully hard to come by in this environment where interest rates are being held low on purpose. In addition, this yield is more than 100 basis points higher than the stock’s five-year average of 2.7%. Moreover, the company is due for a dividend increase later this month, pushing that yield, on a forward-looking basis, even higher.
It’s wonderful to know that you’re getting a fairly healthy yield backed up by organic growth.
Plenty of income now and what’s likely to be plenty of income growth later. Definitely a lot to like here.
But to determine just what kind of dividend growth we should expect moving forward, we first need to look at the underlying business.
I generally like to look at a ten-year track record for any business in terms of its top-line and bottom-line growth to see what it’s doing over the long haul.
Principal doesn’t fare as well as some businesses in this respect because of the aforementioned financial crisis – they got hit pretty hard. However, growth has come back with a vengeance over the last five or so years.
We’ll still take a look at the last decade, however, to be true to general analyses. And then we’ll look at a projection for near-term growth moving forward to get a better idea of what to expect.
Principal’s revenue grew from $9.871 billion in fiscal year 2006 to $11.964 billion in FY 2015. That’s a compound annual growth rate of 2.16%.
Not impressive by any stretch, but their results were skewed perhaps disproportionately relative to a lot of other companies in different industries that were also impacted by the financial crisis.
When the stock market collapses, fees can drop sharply due to the simultaneous problems of AUM dropping as prices fall and as investors also pull their assets out.
Nonetheless, Principal is widely diversified in terms of its geographical exposure and its business model – its insurance exposure helped mitigate some of the issues the firm saw during the financial crisis; however, the firm still remains quite sensitive to volatility in the financial markets.
The company’s bottom line fared similarly poorly over the last decade.
Earnings per share increased from $3.74 to $4.06 over this stretch, a CAGR of just 0.92%.
Slightly hampered by an outstanding share count that’s just moderately higher than it was a decade ago, the overall growth here isn’t really anything to write home about.
However, I’d like to contrast this with what Principal has done over the last five fiscal years: revenue has compounded at an annual rate of 8.26%; EPS compounded at an annual rate of 17.23%.
Of course, we see that sensitivity to the financial markets show up here – the broader stock market has been on a tear over the last five years.
But in the end, we invest in where a company is going, not where it’s been.
Looking forward, S&P Capital IQ is anticipating that Principal will be able to compound its EPS at an annual rate of 8% over the next three years, citing growth in its international businesses and the moderating effect of its large insurance exposure.
Any large-scale correction in the financial markets, though, could make this forecast quite aggressive. All in all, S&P Capital IQ is forecasting for Principal’s growth over the next three years to be about half what it was over the last five.
Another area of the business that is pretty solid is the balance sheet.
The long-term debt/equity ratio sits at 0.35, while the interest coverage ratio is over 10.
And profitability is also stout.
Over the last five years, the firm has averaged net margin of 9.28% and return on equity of 9.63%.
Solid numbers that are competitive, but the overall trend for Principal has been upward across these metrics over the last five or so years.
I see this business as one that could be volatile if the financial markets were to suffer another major setback, but the overall quality of the business and the outstanding yield is such that I think the stock makes a lot of sense within a broadly diversified portfolio.
A yield near 4% supported by a low payout ratio and fairly strong dividend growth always deserves a strong look, in my view, especially when backed by strong fundamentals.
One might expect the market to then be pricing this stock at a good premium, but that doesn’t appear to be the case at all.
The P/E ratio is sitting at 9.71 right now, which is about half the broader market. You’re certainly taking on volatility risk with this business, but one would be doing the same thing if they were to own a large basket of stocks. A valuation cut in half, thus, doesn’t make much sense to me. Moreover, that P/E ratio compares pretty favorably to the stock’s own five-year average of 13.5. Most other metrics are notably below recent historical averages, while the yield, as pointed out earlier, is substantially higher than its five-year average.
A valuation about half that of the broader market and a yield almost twice as high? Seems to be cheap, but how cheap?
I valued shares using a dividend discount model analysis with a 10% discount rate and a long-term dividend growth rate of 6.5%. This is on the conservative side of what I usually allow for, but I think it’s warranted given the vulnerability of the dividend. However, this is a long-term outlook, and I think periods of fast dividend growth will offset that volatility. The payout ratio is moderate and the company is clearly committed to a growing dividend. The DDM analysis gives me a fair value of $46.25.
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.
It appears to me that we’ve got a stock selling measurably below what it’s worth. But am I the only one with that opinion? Let’s compare my thoughts with those of some professional analysts that have taken the time to value this stock after getting a good look at the business.
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 PFG as a 4-star stock, with a fair value estimate of $50.00.
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 PFG as a 4-star “buy”, with a fair value calculation of $42.40.
We see some consensus here – the stock definitely isn’t expensive; rather, it may be downright cheap. But I like to average out the three valuation opinions so as to distill it down into one figure we can work with. That valuation is $46.22, which indicates this stock is potentially 17% undervalued.
Bottom line: Principal Financial Group Inc. (PFG) is diversified across multiple financial services and products. The fundamentals are solid, and growth has come roaring back. The yield is appealing by itself, but I think it’s way more appealing when considering that organic dividend growth, with a dividend increase due later this month. And with the possibility for 17% upside, this stock should be on your radar. In fact, I recently initiated a position.
— Jason Fieber
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