Undervalued Dividend Growth Stock of the Week: JPMorgan Chase & Co. (JPM)

There are so many opportunities around us every single day.

Just being alive is a gift, but being alive in any developed country in the 21st century puts you far ahead of pretty much anyone that has ever walked the planet.

Being here in the United States, specifically, is incredible in the sense that one is able to invest in some of the best businesses to ever exist. And one is able to do so quite easily for very little cost.

The Internet has brought about cheap brokerages, and the plethora of research tools available makes it pretty easy for any retail investor to get a good idea of what they’re investing in.

Once upon a time, I didn’t know what I was doing with stocks.

Investing was practically a foreign language.

But after substantial research, I decided that investing in wonderful businesses with longstanding track records of growing profit and increasing dividends made the most sense for me and my capital.

Stocks that pay and grow dividends over long periods of time – dividend growth stocks – tend to, as a group, outperform the broader market, and the growing dividend income itself is a fantastic source of passive income that can be one day used to pay real-life bills.

Moreover, growing dividend income is the ultimate “litmus test” of growing profit; don’t tell me your profit is increasing, show me.

That’s why dividend growth stocks are what my personal, real-money portfolio is comprised of.

And I found a great number of stocks that I ended up buying by perusing David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish has compiled information on more than 700 US-listed stocks that have increased their dividends for at least the last five consecutive years, and it’s truly the best resource I know of if you’re also interested in dividend growth stocks.

It’s taken me six years of my life to collect positions in almost 100 different high-quality businesses that pay and grow dividends, but I didn’t do so at random.

Specifically, I always made sure to value a business so as to buy its stock only when the price was at or below intrinsic value.

See, price is simply how much a stock costs.

But intrinsic value is what a stock is worth.

And without the latter information, the former is practically useless. Value gives context to price. Without knowing value, you cannot possibly know whether or not the price is appropriate.

We know price is easy to come by. Just about any stock quoting site/software will do.

But how do we ascertain intrinsic value?

Well, it’s a bit more complicated in the sense that you can’t just “pull it up” like you can with the price.

However, it’s also not all that difficult, either.

Like I mentioned just above, a lot of tools and resources exist – the Internet has made these tools and resources readily available for just about everyone.

One great resource designed to help an everyday investor go about estimating the fair value of a dividend growth stock is fellow contributor Dave Van Knapp’s valuation lesson, which itself is part of an overarching series of lessons on dividend growth investing.

Once you have an idea of what a stock is likely worth, you can then decide whether or not the price is reasonable.

But it’s always prudent and beneficial to buy a high-quality dividend growth stock only when its price is at or, preferably, below intrinsic value. In the latter case, that would mean a stock is undervalued, and that’s an appealing proposition for a variety of reasons.

First, your yield is higher.

All else equal, a stock’s yield will be higher when its price is lower. Price and yield move opposite of one another; they’re inversely correlated.

That means more income now… and more potential income in aggregate for the life of the investment.

Plus, all future dividend increases will be based off of that higher yield. While a company’s dividend policy (as well as any subsequent increases a company announces) is unaffected by the price you paid for its stock, a 7% dividend increase is naturally more effective off of a 4% yield than it would be off of a 3% yield.

Second, your long-term potential total return is positively affected.

While growing dividend is my focus as a dividend growth investor, one’s total return is also positively affected when paying less by virtue of buying undervalued dividend growth stocks.

You first benefit from the higher yield, which is one component of total return.

And then you benefit by the nature of the upside that exists between the price you paid and what that stock is likely worth.

When you pay $50 for a stock worth $75, that $25 upside that now exists is a catalyst for additional total return through that capital gain, on top of the natural capital gain you would ordinarily experience as the company becomes worth more as it earns more over time.

Third, your risk is lowered.

After all, is it more risky to pay $50 for a stock worth $75 or $100 for for a stock worth $75?

When you focus on stocks that are undervalued, you have a margin of safety.

That aforementioned potential upside also serves as a margin of safety – if a company doesn’t perform as expected or something goes wrong, you have that “cushion” of $25 per share that wouldn’t have existed had you paid full price.

As such, you can see why I personally focus on high-quality dividend growth stocks that are undervalued.

Fortunately, there appears to be a stock on Mr. Fish’s list that right now appears to be priced less than what it’s likely worth.

Let’s take a look…

JPMorgan Chase & Co. (JPM) is a financial holding company that operates as one of the largest financial institutions in the United States, with over $2 trillion in assets. They offer various financial products and services across traditional retail and commercial banking, asset management, investment banking, and financial transaction processing.

JPMorgan Chase now exists as an absolute banking behemoth, with a market capitalization north of $230 billion.

However, their size doesn’t necessarily make the bank safe from downturns, as results and the dividend suffered immensely during the financial crisis.

Since then, new government regulation has been designed to help curb the likelihood of a similar calamity in the future.

Moreover, the bank has made up substantial ground in terms of its dividend, increasing it now for five consecutive years.

jpmAnd over that stretch, they’ve grown it at a compound annual rate of 53.1%.

Obviously, that’s incredible.

But much of that was possible because the bank came off of such a low dividend and payout ratio after cutting its dividend during the depths of the crisis.

For perspective, the most recent increase was 10%, and that, in my view, is a more realistic expectation for dividend growth over the foreseeable future.

The good news is that even with that monstrous dividend growth, the company still maintains a very moderate payout ratio of 29.8%.

As such, I think dividend growth in that low double-digit range is certainly plausible for at least the next few years, even absent similar EPS growth to match it. Said another way, the payout ratio offers some flexibility regarding dividend growth.

This is all on top of the very solid yield of 2.87% the stock offers right now.

That yield, by the way, is notably higher than what the broader market offers. It’s also more than 30 basis points higher than the stock’s five-year average yield of 2.5%.

So we see this undervaluation already start to show up in the form of more income, which could potentially positively affect one’s long-term total return in a big way.

Plus, it’s just plain more income immediately, and more income on an ongoing basis, too.

But to really take a stab at what the business is worth, we first need to know what kind of growth to expect.

And there’s no better way to formulate an expectation for growth than to look at what a company has done over a long period of time.

We’ll look at JPMorgan Chase’s top-line and bottom-line growth over the last 10 years first, then we’ll look at a forecast for near-term profit growth. Combined, that should tell us a lot.

The company has increased its revenue from $61.437 billion in fiscal year 2006 to $93.453 billion in FY 2015. That’s a compound annual growth rate of 4.77%.

Meanwhile, earnings per share is up from $4.04 to $6.00 over this period, which is a CAGR of 4.49%.

Now, there are a few things to consider here.

This period was one of unprecedented turmoil for the major banks. So the fact that JPMorgan Chase eked out positive growth at all over this period is impressive. There were a number of other large banks that went under during the financial crisis.

But that leads me to another major consideration…

JPMorgan Chase swallowed up a significant chunk of what was formerly Washington Mutual during the depths of the crisis. They then acquired Bear Stearns.

These transactions had the effect of increasing the size and footprint of JPMorgan Chase rather substantially.

It’s unlikely that these kinds of transactions will be available (or even approved) in the future, making organic growth all the more important.

Taking a look at what to expect for the near term, S&P Capital IQ predicts 3% compound annual growth for JPMorgan Chase’s EPS over the next three years, citing low interest rates, challenging investment banking conditions, and higher loan loss provisions due to higher net chargeoffs relating to weakness in several commodity industries.

Overall, though, JPMorgan Chase sits in a very competitive position. Rising rates could be a significant long-term tailwind, if/when rates rise.

The debt position puts them at a similar leverage level to peers, with the bank sporting a long-term debt/equity ratio of 1.25.

Standard & Poors rates their long-term debt A-. Moody’s rates it A3. Both are excellent.

Profitability is solid, though there’s room for improvement across the board.

Over the last five years, the firm has averaged net interest margin of 2.35%, return on assets of 0.88%, and return on equity of 10.04%.

I think there’s a lot to like here. But the near-term remains challenging with low interest rates, tough conditions across many industries, concerns over global growth, and tighter regulation almost across the board.

As such, we want the right price. We want to buy this stock only when it’s undervalued.

Is the price right? Does it appear to be an undervalued dividend growth stock?

The P/E ratio is sitting at 10.40 right now, which is about half that of the broader market. That’s in line with the stock’s five-year average, and so is the price-to-book ratio (1.0). But the yield is significantly higher than it’s averaged over the last five years, and the bank is in a very competitive position. This is a stock that has seemingly been cheap for a while now, which seems to be still cheap.

But how cheap might it be? What’s a reasonable estimate of its intrinsic fair value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term dividend growth rate. That growth rate is on par with what I figure for major peers. I’m factoring in the low payout ratio and strong recent dividend growth, moderated by the forecast for near-term EPS growth. Overall, though, this seems like a good long-term expectation. The DDM analysis gives me a fair value of $62.77.

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.

So the stock appears roughly fairly valued right now, though one could make an argument I’m being pretty conservative. What do some professional analysts that track and value this stock think about its valuation?

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 JPM as a 3-star stock, with a fair value estimate of $66.00.

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 JPM as a 4-star “buy”, with a fair value calculation of $83.30.

Looks like I came in with the lowest figure. Again, you could argue I was being conservative. Nonetheless, averaging out these three valuations gives us a final valuation of $70.69, which indicates the stock is potentially 15% undervalued right now.

jpm scBottom line: JPMorgan Chase & Co. (JPM) is a far larger and more diverse company than it was a decade ago. And it’s competitively positioned. However, it also faces low interest rates and dismal conditions in a number of major industries. But the long-term picture remains bright and the stock appears to offer 15% upside on top of a yield near 3%. This kind of income and possible upside should be seriously considered.

— Jason Fieber

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