Undervalued Dividend Growth Stock of the Week: Walt Disney Co. (DIS)

Dividend growth investing has served me incredibly well over the last six years of my life.

I was broke six years ago.

In fact, I was below broke: I was worth a negative amount of money. My assets were worth less than my liabilities, which is really a terrible situation to be in when you’re in your late 20s.
But I realized I had to turn things around.

So I started saving my money and investing that capital into high-quality dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list.

The result?

A dividend growth stock portfolio that’s valued near $300,000, spitting out five-figure annual dividend income that’s almost surely set to grow organically for the rest of my life.

This strategy and the dividend income I’m now collecting has helped to put me in a position of financial independence in my early 30s.

Dividend income is truly wonderful.

It’s a completely passive source of income, allowing one to pursue a life of passion and/or leisure rather than toil, if one’s dividend income is enough to cover one’s expenses in life.

But growing dividend income is even better.

Because of inflation, a dollar today will almost surely be worth less in the future. So one wants to make sure their purchasing power holds weight. A $100 dividend check, while impressive, is simply unlikely to go as far a decade from now. Rent, food, and pretty much everything else is likely to be, in aggregate, more expensive in the future.

But that’s why I love dividend growth stocks.

These stocks tend to hand out larger dividends year in and year out.

While I’ve had to fight tooth and nail for pay raises at most jobs I’ve held over my life, the stocks in my portfolio, in aggregate, hand me pretty nice dividend increases regularly and reliably.

As a company is able to earn more money from the goods and/or services it provides the world, it’s simultaneously able to increase its dividends to shareholders.

A dividend is, after all, a shareholder’s rightful claim of a portion of the profit a company generates.

Well, one would then expect a bigger dividend if profit is likewise bigger.

That growing dividend income is the “proof in the pudding; dividends are paid in cash, from cash. You can’t write a check you can’t cash. So just imagine writing out ever-larger checks for years and years on end. The profit has to be there to support that behavior.

And so growing dividend income also means one’s purchasing power should remain intact, or even increase, over the long run.

I’ve certainly witnessed this firsthand, with the vast majority of the stocks in my portfolio growing their dividends much faster than inflation.

So instead of worrying about making a dollar stretch further, dividend growth investors will, for example, see a dollar turn into $1.07, then $1.15, then $1.34. So on and so forth.

But as great as these stocks tend to be, one shouldn’t just go out and buy any stock at any price.

Paying attention to a stock’s valuation is imperative.

See, price and value are not one and the same.

Price is how much you must pay to acquire something; value is what that something is actually worth.

As you can imagine, paying $100 for something worth $50 is a bad idea. Conversely, paying $10 for something worth $50 is likely to turn out really well for you. Illustrative examples here, but I think the point is clarified.

It’s that latter scenario, in which a dividend growth stock is markedly undervalued, that should get a dividend growth investor pretty excited.

That’s because undervalued dividend growth stocks tend to come attached with a higher yield, stronger long-term total return prospects, and less risk.

The higher yield is a function of the lower yield. All else equal, price and yield move opposite of one another, being inversely correlated. So a lower price should allow for a higher yield.

That higher yield is more income in your pocket – both immediately and potentially for the life of the investment.

In addition, that higher yield, which is more income, improves the stock’s potential long-term total return since yield is a major component of total return.

Capital gain, the other component, is also positively influenced by the gap that exists between price and value. If you pay 20% less than a dividend growth stock is worth, that 20% gap exists as possible upside. If that gap closes – the market tends to realize value over the long run – capital gain occurs.

That 20% gap is also a margin of safety. If the company does something wrong or something else unforeseen happens that puts a dent in the company’s value, you have a cushion already built in when you snag a dividend growth stock when it’s undervalued.

The margin of safety is reduced risk. Moreover, paying less for a stock means you’re naturally either expending less cash per share or spending less outright on the total investment. Either way, you’re risking less.

Fortunately, this day and age has made valuing dividend growth stocks easier than ever.

There are now a multitude of tools, resources, and guides designed to help everyday investors value stocks, with many specifically designed for dividend growth stocks.

And one such resource is freely available right here on the site.

One lesson out of his overarching series of lessons on dividend growth investing, it’s a valuation guide that demystifies the process, making it relatively easy to estimate a dividend growth stock’s intrinsic value.

I recently put one well-known and high-quality dividend growth stock through the paces, and it appears to be measurably undervalued right now.

This is a wonderful business with tremendous earnings power that is likely to continue growing for decades to come, which portends bigger dividends, too, for many, many more years.

Best yet, its stock appears to be priced less than it’s intrinsically worth…

Walt Disney Co. (DIS), together with its subsidiaries, operates as a global diversified media and entertainment conglomerate.

This company is more than just theme parks, much more.

It’s really two extremely strong but complementary operations.

One one hand, you have the Media Networks business segment, which comprised just over 44% of last fiscal year’s revenue, mostly made up of ESPN and ABC, along with a number of other networks and production studios.

On the other hand, you have a number of other businesses that rely on the Disney brand, which includes the Studio Entertainment, Consumer Products, Parks and Resorts, and Interactive business segments.

So you have the strongest cable network out there – ESPN sports the highest affiliate fees per subscriber (among all cable networks) by focusing on, well, sports.

And since consumers like to watch sports live, this channel should continue to profit handsomely even as consumers continue to change the way they watch television, moving away from traditional cable packages.

In addition, ABC is one of the four major domestic broadcast networks, with sports rights of its own and a slew of original programming. ABC is currently broadcasting the NBA Finals matchup between the Cleveland Cavaliers and Golden State Warriors, with viewership numbers for Game 1 the highest for a Game 1 since 1998.

If that was all there was to Walt Disney, you’d have a pretty solid business.

But you then have monster theme parks like Walt Disney World; cruise lines; an incredible line of licensed toys and games; a library of well-known characters like Mickey Mouse, Elsa, Little Mermaid, Luke Skywalker, and Donald Duck; and a studio that puts out hits like Frozen, Star Wars 7: The Force Awakens, and The Avengers.

This is really one of my favorite businesses, and, in my view, one of the highest quality out there.

And they continue to share their growing profit with shareholders, with six consecutive years of dividend increases under their belt after keeping the dividend static for a few years during the financial crisis.

One of the more prolific dividend growers over the last five years, their dividend growth rate stands at 31% over that period.

CaptureWith a payout ratio of just 26.2%, I’d expect many more sizable dividend increases to come.

The only thing that could be considered a drawback as far as the dividend is concerned is the yield, in my view.

At 1.44%, there’s probably something to be desired there for any investors out there seeking current income. That’s lower than the broader market, but I think it’s made to be a bit more attractive in this environment of extremely low rates.

Furthermore, that demonstrated dividend growth over the last few years and potential for plenty more is substantial. And I think that makes up for much (or all) of that low starting yield.

But in order to determine the capability of the company to continue handing out these sizable dividend “pay raises”, we must first look at what kind of underlying growth the firm is capable of.

Well, there’s no better place to start than by seeing what they’ve done over the last decade, which should smooth out short-term headwinds and cycles.

We’ll then compare that to a near-term prediction for profit growth.

When blended together, we should have an idea of what to expect in terms of profit growth moving forward. That’ll go a long way toward putting forth a dividend growth expectation.

Walt Disney’s revenue has increased from $34.285 billion in fiscal year 2006 to $52.465 billion in FY 2015. So we’re looking at a compound annual growth rate of 4.84% here for the top line.

Not spectacular, but I think it’s important to consider the size and scale of this company. It’s not growing to increase revenue rapidly due to its mature state and overall size, but the company thankfully has a few levers to pull in order to grow its profit on a per-share basis a bit more aggressively.

Moreover, this revenue growth wasn’t lumpy at all; it was almost completely linear, even through the Great Recession.

Earnings per share, meanwhile, improved from $1.64 to $4.90 over this stretch, which is a CAGR of 12.93%.

Definitely a disparity here, but it’s explained when you look at the financial statements.

Primarily, Walt Disney reduced its outstanding share count (meaning net income is divided between less shares) and improved its profitability. Both were significantly beneficial.

The outstanding share count, for instance, is down by approximately 18% over the last decade, which is a sizable reduction for such a large company.

Looking out over the near future, S&P Capital IQ believes Walt Disney will grow its EPS at a compound annual rate of 11%, which really isn’t too far off from what we see above. S&P Capital IQ believes currency headwinds and increased programming costs at the networks will be more than offset by the growth potential across the entire business.

Fundamentally, the rest of the business is extremely sound, if not incredible.

The balance sheet is in excellent condition, with a long-term debt/equity ratio of 0.29 and an interest coverage ratio that exceeds 53.

That means Walt Disney’s earnings before interest and taxes can cover interest expenses more than 50 times over.

While a lot of other businesses have loaded up on cheap debt, Walt Disney’s balance sheet has actually improved over the last decade.

Profitability has also improved rather markedly.

Over the last five years, the firm has averaged net margin of 14.03% and return on equity of 15.45%.

Both numbers are outstanding in both relative and absolute terms, especially when comparing them to what they were over the prior five-year period.

What we have here is a Walt Disney that’s bigger and better than ever before, in my opinion.

Recent acquisitions of Marvel Entertainment and Lucasfilm give Walt Disney a whole new library of iconic characters, which they’re using to craft new, exciting content. And this company knows how to leverage its content and characters with powerful cross-promotion, branding, and licensing.

These acquisitions also slowly move the company away from its reliance on ESPN, which is coming under fire due to the fact that consumers are moving away from traditional cable packages. Combine that with the opening of the massive Shanghai Disney Resort, and you can see a company that is becoming bigger and more diverse, with plenty of growth opportunities still ahead.

Meanwhile, the Media Networks segment saw 10% year-over-year revenue growth, so I don’t really see a lot of merit for major concern there.

Walt Disney is more efficient, less leveraged, and earning more profit with less shares to spread that profit across compared to where it was a decade ago.

Yet the stock is now less expensive than it was in 2006…

The P/E ratio sits at 18.19 right now. It was over 21 in 2006. The five-year average is 19.3, so you can see a gap here that exists, most likely to close over time (that’s “upside”). Furthermore, that current P/E ratio is also well below the broader market. I believe this stock actually deserves a premium to the market. Yet it’s priced at a discount.

One of the best businesses in the world trading for less than the market? Bigger and better than it was a decade ago, yet cheaper? Seems like a good time to buy, but what’s the value of this stock? What’s a good estimate of its worth?

I valued shares using a two-stage dividend discount model analysis to account for the low yield and high growth. I factored in a 10% discount rate and 20% dividend growth rate for the first ten years. With the low payout ratio and current aggressive dividend growth, this seems like a good bet. I then assumed a 7% terminal dividend growth rate. The DDM analysis gives me a fair value of $144.54.

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 I believe that this is a high-quality dividend growth stock available for a price that’s far below what it’s worth. Am I alone in that belief? It doesn’t appear so…

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 DIS as a 4-star stock, with a fair value estimate of $134.00.

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 DIS as a 4-star “buy”, with a fair value calculation of $104.60.

We’re looking at eight out of 10 possible stars then. And if you blend the three different valuation numbers together, you get $127.71. That would indicate this stock is quite possibly 29% undervalued here.

scBottom line: Walt Disney Co. (DIS) is an incredible business, spread out across virtually every facet of entertainment. It’s operationally excellent, growing at a rapid pace, and should be able to deliver shareholders plenty of dividend raises for years to come. Plus, the stock appears to offer 29% upside. This might just be one of the best dividend growth opportunities available right now.

— Jason Fieber

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