I’ve really stuck to a very simple mantra over the years as I’ve built up the six-figure portfolio that now generates growing passive dividend income that covers most of my core personal expenses.
That mantra is this: buy the highest-quality dividend growth stocks at the lowest possible valuations.
The reason why I like to stick to high-quality dividend growth stocks is because when one is doing that, they’re generally investing in great businesses that are so routinely increasingly profitable that they basically gush cash, being in a great position to return what they can’t use to shareholders via growing dividends.
You can see what I mean by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.
I mean, you’ll find hundreds of companies that have sent out increasing dividends to shareholders for decades.
I don’t know how one would run a poor business but simultaneously write larger and larger checks to shareholders every year for years on end. I don’t know how you can do those two things at the same time.
So not only is one generally sticking to great businesses by investing in high-quality dividend growth stocks but the growing dividend income itself serves as a great source of passive income, which can one day be used to cover one’s personal expenses.
This is largely how I became financially free in my early 30s.
But there’s another side to that mantra, which involves making sure the valuation at the time of purchase is attractive.
Said another way, you want to buy these high-quality dividend growth stocks when they’re undervalued.
The reasoning is really straightforward.
It works similarly if we’re talking about anything else in life.
Say a loaf of bread is worth $2. If it’s instead priced at $1, you’re in much better shape.
You can buy twice as much bread for the same money, first off.
Second, you’ve added a margin of safety there just in case the bread is stale or doesn’t taste good.
You’re out less money in case something goes wrong.
Well, an undervalued dividend growth stock (compared to if it were fairly valued or overvalued) will come with a higher yield, less risk, and greater long-term total return prospects.
Price and yield are, all else equal, inversely correlated.
When the price of a stock goes down, its yield will correspondingly rise (unless some change to the dividend is made at the corporate level).
So this means more income right from the start. In addition, it means more ongoing income, too.
You get the additional income right away from the higher yield. But this almost always has a cumulative effect on your income for the life of the investment, too.
Of course, this also has the effect of increasing one’s long-term total return prospects since yield is a major component of total return.
Meanwhile, the other component, capital gain, is potentially given a big boost by the gap that exists between the lower price paid and the higher worth of the stock. While it could take a while for that gap to close, value matters over the long run. This “upside” is on top of any long-term potential the stock already has by virtue of the operations of the underlying business.
And all of this reduces one’s risk, as well.
You have the opportunity to spend less in absolute dollars (by purchasing a static amount of shares) when a stock is priced lower. That means you’re just plain risking less overall capital.
But even if you decide to purchase more shares (by investing a static amount of capital), you’re still introducing a margin of safety whereby the company could not perform as expected but you’d still do okay.
If a stock is deemed to be worth $50 but you buy in at $30, you have $20 worth of a margin of safety. That means the value of the stock would have to drop more than 40% before the purchase would be thought of as a mistake.
What’s great about all of this is that it’s not terribly difficult to value a dividend growth stock before you buy it, which allows you to right then and there decide whether or not it’s undervalued, conferring all of these aforementioned advantages.
For instance, a great valuation resource is available right here on the site.
Put together by fellow contributor and dividend growth investor Dave Van Knapp, it’s a valuation tool that’s designed to simplify and streamline the whole process.
It’s one of his overarching series of lessons on dividend growth investing, and it’s definitely worth checking out.
So let’s take a look at one high-quality dividend growth stock that appears to be undervalued right now.
T. Rowe Price Group Inc. (TROW) is a global investment manager that provides asset management services for institutional and individual investors.
With just over $776 billion in assets under management as of June 30, 2016, T. Rowe Price Group is one of the largest asset managers in the United States.
Even more impressive than the size of the business is their track record for boosting dividends to shareholders.
They’ve paid an increasing dividend for 30 consecutive years now, which is obviously made to be even more incredible when you consider the industry in question here.
Through multiple stock market crashes over the last 30 years, which affects their AUM, they continued to pump out bigger dividend checks to shareholders. Pretty incredible stuff.
Not only that but the rate at which they’ve been increasing the dividend is really amazing: the 10-year dividend growth rate stands at 16.3%.
Couple that with a yield of 3.14% and you have one of the most appealing relationships between yield and dividend growth I know of.
Not only is that yield well in excess of the broader market but it’s also almost 100 basis points higher than the stock’s own five-year average yield of 2.2%.
And with a payout ratio of just 52.2%, there’s still plenty of room for the company to continue handing out dividend increases for years to come.
However, there are some caveats here.
Namely, the most recent dividend increase (announced earlier this year) was less than 4%, which is the lowest dividend increase I’ve ever seen from this company.
And the strong stock market has been masking some modest outflows, which is concerning when considering that the trend in asset management is for clients to move to low-cost passive funds (which T. Rowe Price Group lacks exposure to).
However, T. Rowe Price Group’s incredible long-term track record in terms of their management performance does shield them somewhat, and they’re faring a lot better than some other firms in this industry; they have a very strong brand.
Furthermore, their target-date retirement funds have proved to be quite successful in regards to inflows.
So what does this all add up to?
Let’s find out by looking at their top-line and bottom-line growth over the last decade, which will help us determine not only where the company has been but also, possibly, where it’s going. This will provide key information we need to later value the stock.
Revenue for the company has increased from $1.815 billion to $4.201 billion from fiscal years 2006 to 2015.
That’s a compound annual growth rate of 9.77%.
The bottom line fared a bit better, thanks to modest share repurchases; earnings per share grew from $1.90 to $4.63 over this period, which is a CAGR 10.40%.
Looking out over the next three years, S&P Capital IQ is predicting that T. Rowe Price Group will compound its EPS at an annual rate of 2%. While this would be a steep drop from what we’ve seen over the last decade, their results will be in large part underpinned by the performance of equities over the next three years. The flow of capital will also have a lot to say about this. But outside of a complete collapse in the stock market, stable AUM should provide for a strong base of overall performance moving forward.
The fundamental picture thus far is pretty compelling, but one area of the company’s fundamentals that is particularly strong is the balance sheet.
The company has no long-term debt on the balance sheet, which is just emblematic of a rock-solid company.
And the profitability metrics are about as strong as they come, with the firm averaging net margin of 29.26% and return on equity of 23.75% over the last five years.
Overall, there’s really not much to dislike about this company.
You have excellent fundamentals, a lengthy dividend growth streak, a very appealing combination of yield and dividend growth, and one of the best brands in its industry.
However, modest outflows could be a risk. And the US stock market is sitting near all-time highs; any large-scale correction would have an impact on T. Rowe Price Group’s earnings power.
But it does appear that a lot of the risks are priced into the valuation right now…
The stock is trading hands for a P/E ratio of 16.62 right now, which itself is artificially high due to a one-time hit to Q2 earnings after a proxy error impacted EPS. Nonetheless, this is still much lower than the stock’s five-year average P/E ratio of 20.0. And most other metrics are indicating further cheapness, with the price-to-book ratio a full 20.5% below its five-year average. As mentioned earlier, the current yield is well above its recent historical average.
It does appear to be cheap at this level. What, then, would be a fair price to pay? What’s a reasonable estimate of the stock’s intrinsic value?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate and a 7% long-term dividend growth rate. This growth rate is lower than that I’ve used in the past, accounting for the most dividend recent increase and modest outflows. But I think this is a solid expectation when looking at the long-term record, low payout ratio, and sizable AUM already in place. The DDM analysis gives me a fair value of $77.04.
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 it looks like there’s a margin of safety present at today’s stock price. But am I alone with this perspective? What do some professional analysts think about this stock and 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 TROW as a 3-star stock, with a fair value estimate $77.00.
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 TROW as a 4-star “BUY”, with a fair value calculation of $75.90.
We have a pretty tight consensus here. Averaging out the three valuations gives us a final number of $76.65, which would mean the stock is potentially 11% undervalued right now.
Bottom line: T. Rowe Price Group Inc. (TROW) is a high-quality firm across the board. The combination of current yield and long-term dividend growth is very appealing and hard to find in this market. With the potential for 11% upside on top of a yield that’s significantly higher than its recent historical average, this could be one of the best opportunities available to dividend growth investors at this moment in time.
— Jason Fieber
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