Undervalued Dividend Growth Stock of the Week: Apple Inc. (AAPL)

Price and value.

I believe most people intuitively understand that the two aren’t the same.

Price is what something costs; value, though, is what something is worth.

It’s the latter piece of information that you really need to always know before price. Value gives context to price. Without knowing value, the price of something is almost meaningless.

Almost everything in this world has a price; likewise, almost everything in this world has value, too.

This is never truer than when dealing with stocks.

But the interesting thing about stocks is that one piece of the puzzle changes often, while the other piece doesn’t.

Said another way, you’ll see prices for stocks change almost every second of every trading day.

Up 1% Monday. Down 0.5% Tuesday. Up 2.1% Wednesday. So on and so forth.

However, outside of some major impact, the value of an underlying business just doesn’t change that much from one day to the next.

How, then, do we ascertain value so that we can give context to price?

Well, there are a lot of methodologies and systems out there that exist to help an investor do just that.

One such methodology is (freely) available right here on the site.

Put together by fellow contributor Dave Van Knapp, it’s simplifies the complicated.

This methodology is specifically designed for dividend growth stocks, as part of Mr. Knapp’s lessons on dividend growth investing.

Dividend growth stocks are stocks that routinely and regularly pay and increase dividends to shareholders.

And since a business has to do a lot of things right to increase its dividend for years or decades on end, distilling the thousands of publicly traded stocks down to only those paying and increasing dividends tends to eliminate a lot of low-quality businesses from one’s portfolio.

You can see what I mean by checking out David Fish’s Dividend Champions, Contenders, and Challengers list, which is an incredible resource that tracks all US-listed stocks with at least five consecutive years of dividend increases.

Now, not every stock on Mr. Fish’s list is an investment candidate at any time.

First, you want to make sure you’re investing in a wonderful business that’s within your circle of competence.

While I’ve found this list to be really fertile ground for high-quality stocks, I’ve occasionally stumbled upon businesses that had seen their peak long ago. And I’ve even on occasion added stocks I probably shouldn’t have to my personal portfolio (itself chock-full of high-quality dividend growth stocks).

So it’s vital that you invest in businesses that are growing and high quality. The last thing you want to do is invest in a company that is slowly dying, which will “kill” your capital in the process.

Another very important consideration is valuation.

Specifically, you want to aim to buy high-quality dividend growth stocks when they’re undervalued.

A stock is undervalued when its price is below its worth.

Why should one aim for undervalued dividend growth stocks?

Easy…

First, a dividend growth stock will very likely see a higher yield when its price is lower.

All else equal, price and yield are inversely correlated. Unless a dividend is cut or eliminated, the yield will always be higher when the price is lower.

That means more income in your pocket both now and later.

Second, your potential long-term total return is greater.

Yield is one component to total return; a higher yield thus means your potential total return is greater right off the bat.

But the other component, capital gain, also sees more possible upside due to the gap that exists between price and value when a stock is undervalued.

Third, your risk is lower.

Paying $50 for a stock worth $75 obviously involves less risk than paying $75 for the same stock.

You’re either risking less absolute capital or less capital per share.

Moreover, you build in a margin of safety when you pay significantly less than what a stock is worth.

Paying $50 for a stock worth $75 means you have a $25 “cushion”. The company would have to underperform to a great degree or do something terrible before you’d come out of that deal on the wrong side.

You can now see why I’m always on the hunt for high-quality dividend growth stocks that are undervalued.

Well, one of the biggest companies in the world seems to qualify in a big way.

Is it hiding in plain sight?

Apple Inc. (AAPL) designs, manufactures, and markets a variety of consumer electronics, including smartphones, tablets, personal computers, smartwatches, and portable music players. They’re vertically integrated with software and hardware. They also offer a variety of services designed to be used on and for their products.

Unless you live in a cave, you’re well aware of Apple and its products.

The company has literally changed how people communicate and use electronic devices, changing the world in the process.

Their products are consistently lauded for their intuitive nature – the designs and applications are extremely easy to access and use, and so are the products.

And their ecosystem of integrated software and applications means consumers tend to be quite loyal to Apple products over the long haul.

While Apple’s corporate history and ascent are decades old, the company just recently started paying a dividend.

However, they’ve been increasing it regularly since first initiating it, now with five consecutive years of dividend increases.

Moreover, recent communication from management on this topic indicates that the company fully plans to continue handing out regular dividend increases. There appears to be a pretty clear commitment there.

Like I often see with companies starting out with a 0% payout ratio (no dividend), the dividend growth here has been pretty phenomenal.

The three-year dividend growth rate stands at 38.9%, which is incredible.

But I wouldn’t expect that kind of huge double-digit dividend growth to continue on – the most recent dividend increase of ~10% is a pretty good figure to base near-term expectations upon.

With a payout ratio of just 25.4%, however, they could be even a bit more aggressive than that for at least the next decade.

The good news is that you’re combining that huge dividend growth potential (due to the very low payout ratio and the strong underlying growth we’ll go over shortly) with a pretty appealing yield of 2.43%.

That yield is quite a bit higher than what the broader market offers. And you’re likely going to see much greater dividend growth over both the near term and long term with this stock.

I think, overall, the potential for substantial dividend growth for years to come is really strong here.

appleThe low payout ratio is just one aspect of that assumption, however.

The company’s underlying profit growth is another.

So we’ll first take a look at what Apple has mustered in terms of revenue and profit growth over the last decade. And then we’ll compare that to a near-term forecast, which will combine to put a pretty clear picture together for us. That’ll also help us immensely when the time comes to value the business.

Apple’s revenue has increased from $19.315 billion to $233.715 billion from fiscal years 2006 to 2015. That’s an astounding compound annual growth rate of 31.92%.

While incredible, it’s highly unlikely we’ll see anything close to that ever again from Apple.

They’re now working from a revenue base more than 10 times higher than it was a decade ago.

And smartphone penetration is now higher than ever, leaving less future growth in that area of the business. Since iPhones accounted for 66% of Apple’s revenue for FY 2015, that’s a major headwind.

The bottom line fared even better, believe it or not. Thanks to a steady improvement in margins and a reduction in the outstanding share count, earnings per share growth was propelled a bit more than it ordinarily would have been.

EPS increased from $0.32 to $9.22 over this period, which is a CAGR of 45.27%.

Looking forward, S&P Capital IQ believes that Apple will compound its EPS at a 9% annual rate over the next three years. While this would be about 1/5th of what Apple has managed over the last decade, it would still be very acceptable and attractive growth, if it comes to pass.

The company’s other fundamentals are very high quality, just like what we’ve already seen.

The balance sheet is a good example.

While the long-term debt/equity ratio of 0.45 indicates a very solid balance sheet, the company’s financial position is actually rather incredible.

First, consider the interest coverage ratio is almost 100.

And then consider that they have over $200 billion in cash and securities.

The only issue with that cash, however, is that the vast majority of it is overseas, and the company is unlikely to repatriate due the massive tax bill that would be triggered.

Profitability is likewise outstanding.

Over the last five years, the firm has averaged net margin of 23.35% and return on equity of 39%.

The margins are huge, and they’ve steadily improved over the last decade.

It seems that Apple’s focus on creating products that are easy to use and beautifully designed has translated phenomenally, and creating an ecosystem of software and applications keeps customers coming back over and over again. This allows the company to charge a premium, which has led to that margin.

Recent results, however, have sharply fallen – the most recent quarter saw Apple register its first drop in revenue since 2003. Increased competition, a slowdown in China, and the proliferation of smartphones (leading to less demand) are all issues for Apple.

But the valuation is also way lower than it was during Apple’s more heady days…

The stock’s P/E ratio is a lowly 10.46 right now. That’s about half the broader market. It’s also markedly lower than the stock’s five-year average P/E ratio of 14.3. Every other basic valuation metric is much lower than its respective five-year average. The company might not be growing as much as it used to, but it’s pretty close to being valued as if it’ll never grow again.

That seems like a very low valuation for a company like this. But what would a fair valuation be? What’s a fair price?

I valued shares using a dividend discount model analysis with a 10% discount rate and an 8% long-term dividend growth rate. That growth rate is reasonable even if Apple’s underlying EPS growth disappoints. The low payout ratio allows for a lot of flexibility. The DDM analysis gives me a fair value of $123.12.

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 is an undervalued dividend growth stock hiding in plain sight. And it seems like Warren Buffett’s company agrees – Berkshire Hathaway Inc. (BRK.B) just recently opened a position in Apple worth almost $1 billion. Let’s next compare my perspective to the that of some professional analysts that have taken the time to analyze and value 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 AAPL as a 4-star stock, with a fair value estimate of $133.00.

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 AAPL as a 5-star “strong buy”, with a fair value calculation of $93.70.

I’m definitely not alone here, then. Averaging out the three valuations gives us a final number of $116.61. That would mean this stock is potentially 24% undervalued right now.

sc aaplBottom line: Apple Inc. (AAPL) is a high-quality firm across the board. The fundamentals are about as good as they get, and the dividend is highly likely to continue growing at an aggressive rate. Although the company can’t continue growing at a phenomenal rate forever, the stock is priced as if the company will grow very little forever. The possibility for 24% upside seems to warrant a bet that they’ll do much better than that.

— Jason Fieber

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