There are many ways to build wealth in this world.
You could build your own successful business, invent the next “big thing”, spend your whole life climbing the corporate ladder, or become a celebrity.
Just a few examples here.
Notice I said there are a lot of ways to build wealth; I didn’t say they’d all be easy.
Fortunately, one doesn’t need to become a leading actor in Hollywood to become very wealthy in life.
I spent my career in the auto industry, working as a service advisor for car dealerships.
Earning $60,000 was a great year for me.
I had a negative net worth in 2010 – just six years ago.
And yet here I am at 33 years old, controlling a portfolio that’s well into the six figures.
Better yet, the passive income I earn – most of which is comprised of the dividend income my portfolio generates – covers my core personal expenses, rendering me financially independent.
How did this happen?
All I did was live well below my means and invest my savings into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.
Save. Invest. Reinvest dividends. Rinse. Repeat.
So while a number of life paths that can lead you to wealth can be very difficult to traverse, amassing wealth and freedom doesn’t have to be hard at all.
But things are always easier said than done, right?
Well, I’m not sure about that.
But I do think that one should focus on quality and valuation when the time comes to buy dividend growth stocks.
The good thing about quality, though, is that’s almost built right into the dividend growth investing strategy.
When I think of a company that’s high quality, I think of the kind of resiliency and consistency that lends itself to paying increasing dividends for years or decades on end.
Those growing dividends, of course, being funded by growing profit.
And this growing profit is possible because a company is selling products and/or services that the world demands.
Combine an ever-increasing global population with the ability to raise prices, and you have a fantastic recipe for more profit over time.
So it’s a virtuous circle, with growing dividends being kind of a “litmus test” of quality.
But the other area of focus, valuation, is just as important, if not more so.
After all, no company is worth any price.
The price you pay for stock will have a direct and lasting impact on both your wealth and your dividend income.
This is why I always aim to acquire high-quality dividend growth stocks when they’re undervalued.
Check it out…
A dividend growth stock that’s undervalued will feature a higher yield, better long-term total return prospects, and less risk.
This is all, of course, relative to fair value or higher. That is to say, the lower the price you pay and the more undervalued a stock is, the stronger all of these aspects will be.
It’s easy to see how this works.
First, price and yield are inversely correlated.
All else equal, a stock’s yield will be higher when its price is lower.
So that’s more passive income (more money) in your pocket both initially and, potentially, for the life of the investment.
That in turn positively impacts the long-term total return prospects, with yield being one of two components of total return.
The other component, capital gain, is also potentially positively impacted by virtue of the upside that then exists between price and yield.
If a stock is worth $50 but you pay $30, you have potential “upside” there of $20 per share.
While the stock market is awfully emotional in the short term, value tends to shine true over the long run. As such, there’s a good chance that the stock’s true value becomes known, causing the price to rise in kind.
In addition, that gap between price and value acts as a margin of safety.
Just in case the business does something unexpected that negatively impacts your investment, you have a margin of error worth $20 per share – the company’s fair value would have to be permanently impacted by at least $20 per share before you’re really “in the hole”.
That acts as a buffer, to limit risk.
And, of course, we’re talking about just plain spending less money per share, which could mean you’re risking a lesser total capital outlay, depending on how many shares you’re purchasing.
What’s great about all of this is that it’s not terribly difficult to value high-quality dividend growth stocks, thus determining whether or not the price confers all of these benefits.
One valuation method is freely and easily accessible right here on the site.
Put together by fellow dividend growth investor and contributor Dave Van Knapp, it takes pretty much all of the difficulty out of valuing dividend growth stocks.
With all of that said, what does this look like in real-time?
Read on to find out because I’m going to discuss a dividend growth stock that right now appears to be substantially undervalued.
Lazard Ltd. (LAZ) offers corporate advisory and asset management services.
Not a company that’s particularly well-known, but it’s often these companies that fly way under the radar that provide fantastic long-term income and total return potential.
Founded in 1848, this company has been in business for a very long time. However, they completed an IPO in 2005, meaning their history as a public entity is relatively limited.
However, they’ve built a huge network over the last 150+ years – both in terms of relationships and its physical footprint.
They have offices in over 40 key cities around the world.
And they’re one of the largest players in the merger & acquisition space, having a hand in some of the biggest corporate deals worldwide. Indeed, they were involved in five of the top 10 largest M&A transactions announced in 2015.
They operate two different but complementary segments. Both contribute a roughly equal portion of revenue, meaning Lazard is approximately equally split between the two segments.
The financial advisory side of the house offers advice relating to M&A, as well as restructuring.
They then also have a large asset management business that currently has over $180 billion in assets under management.
Since the company went public in 2005, there isn’t a multi-decade dividend growth track record present quite yet – the company simply hasn’t yet had the opportunity to build something like that.
However, they have increased their dividend for nine consecutive years.
While they may lack that lengthy track record, the company has made up for it with a huge dividend growth rate over the last few years.
The five-year dividend growth rate stands at 22%, which is just massive.
Notably, they started out with a payout ratio of 0% a decade ago, so I don’t anticipate that type of monster dividend growth to continue on indefinitely.
However, the most recent dividend increase (announced just months ago) was over 8%.
That’s still an incredibly solid dividend increase in absolute terms.
Moreover, consider that the stock yields an incredible 5.17% right now.
Not all that often you’re going to get 8% dividend increases on a yield of over 5%.
With a payout ratio of 42.2% (using adjusted earnings), we can see that there’s plenty of room for the dividend increases to continue flowing.
Not only that but that yield is more than twice as high as the stock’s own five-year average yield of 2.5%.
So investors buying this stock today are “locking in” a yield that’s twice as high as what it’s typically been, on average, over the last five years!
In addition, the company routinely pays out special dividends. They paid a special dividend of $1.20 earlier this year, which, when combined with the quarterly dividends, pushes the yield near 10% this year.
So just really exciting and incredible numbers here regarding the dividend.
But we definitely want to know if the dividend is sustainable. And to know that, we must look at what kind of growth the underlying business is generating.
Revenue and profit growth will also tell us a lot about what the company and its stock might be worth.
I always like to consider a decade’s worth of growth, which helps smooth out short-term issues and fluctuations that can negatively impact numbers.
Lazard has grown its revenue from $1.494 billion to $2.354 billion from fiscal years 2006 to 2015. That’s a compound annual growth rate of 5.18%.
Meanwhile, the company’s earnings per share increased from $2.31 to $3.60 (adjusted) over this same period, which is a CAGR of 5.05%.
It’s important to be mindful of the lumpy results over the last decade, though. The growth was certainly not a smooth, secular move up. M&A can be notoriously inconsistent, and so Lazard isn’t necessarily in control of its own destiny with that side of the business. However, the asset management side of the company has been far more consistent.
Looking forward, S&P Capital IQ believes that Lazard will compound its EPS at an annual rate of 13% over the next three years, citing the likelihood of more M&A in light of strong corporate cash levels. Predicting M&A activity, and thus Lazard’s EPS growth, is certainly very difficult, so I would take this forecast with a grain of salt, as always.
An area that’s always of interest but particularly so with companies like this is the balance sheet.
Fortunately, Lazard passes with flying colors.
The long-term debt/equity ratio is just 0.76.
If that’s not good enough, consider the company has cash and equivalents that exceed long-term debt.
Great stuff, indeed.
Profitability has varied quite a bit over the last decade. As mentioned just earlier, the advisory services can be quite strong one year but be quite weak in another. The long-term picture appears to be quite bright, however, and this is a company that’s been in business for more than 150 years.
Over the last five years, though, Lazard has averaged return on equity of 45.96% and return on assets of 10.44%.
Just really strong numbers across the board here.
Furthermore, I like that this business is unlikely to be usurped by new technologies. In my view, I don’t see corporate M&A being somehow easier due to the Internet or automation. This is an industry that should stay strong and insulated for many years to come.
The asset management side of the business, however, is facing some serious and long-term threats from the rise of passive funds/management. So while asset management offers more consistency, it could actually be under greater duress over the next decade or so.
In addition, investors should be aware that this company issues K-1 forms. Being based in Bermuda, however, does not impact US investors’ dividend payments; there’s no foreign withholding dividend taxation to worry about.
This all said, I think the valuation more than factors in the risks.
In fact, the stock looks extremely cheap here…
The P/E ratio sits at 8.78 (using adjusted TTM EPS). That’s a P/E ratio that effectively valuing the company for no growth at all moving forward, permanently. That’s less than half the broader market. And the yield, as noted above, is twice its five-year average. Every other basic valuation metric that I can see for the stock is roughly half its respective five-year average.
Wow. That is awfully cheap for what we’re getting here. What’s the stock likely worth, then?
I valued shares using a dividend discount model analysis. I assumed a 9% discount rate and a long-term dividend growth rate of just 5%. That growth rate is in line with the company’s long-term top-line and bottom-line growth, which I think is reasonable. However, this could prove to be conservative – the forecast for near-term EPS growth is far higher, and the dividend has grown rather aggressively. Furthermore, this isn’t factoring in special dividends. The DDM analysis gives me a fair value of $39.90.
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 my conservative valuation method still seems to indicate this stock is dramatically undervalued right now. Am I alone in this thought process?
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 LAZ as a 5-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 LAZ as a 4-star “buy”, with a 12-month target price of $45.00.
I came in the lowest out of the three, but averaging these three figures out gives us $44.97. That would mean this stock is quite possibly 54% undervalued at this time.
Bottom line: Lazard Ltd. (LAZ) has been around for more than 150 years, carving out a very strong and insulated business in the process. The yield is over 5%, they pay special dividends regularly, and the stock appears to offer 54% upside. This could be one of the best long-term opportunities available right now for dividend growth investors.
— Jason Fieber
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