With the stock market seemingly getting more expensive by the day, it’s never been more important to focus on value.
While price is simply what something costs, value tells you what something is worth.
As such, it’s really value that’s the far, far more meaningful piece of information. Value gives context to price.
Just imagine that you’ve been shopping at a certain grocery store for the last five years. And imagine, much like the stock market, the prices of a lot of merchandise in that store rose somewhat substantially over that time frame.
You’d be particularly vigilant to grab the sales flyer at the front of the store, wouldn’t you?
Well, that’s what today’s article is all about.
In any market, I try to put my capital to work by investing in undervalued high-quality dividend growth stocks for the long haul.
That’s largely how I built the six-figure portfolio that allowed me to essentially retire in my early 30s.
High-quality dividend growth stocks are by far my favorite stocks.
After all, a shareholder is really the part-owner of any publicly traded company.
And as someone who owns a tiny sliver of a business, I demand my rightful sliver of the profit a company generates.
That’s where dividends come in. They’re a portion of a company’s profit.
Of course, I’m only interested in investing in companies that are growing. And so as profit grows, so should my dividends.
It all works hand in hand.
As such, a lengthy track record of increasing dividend payments to shareholders is a great initial litmus test for quality.
And that’s why I like to use David Fish’s Dividend Champions, Contenders, and Challengers list as my “shopping list” when it comes time to buy stock.
Mr. Fish has compiled extraordinary information on more than 700 US-listed stocks – all of which have paid increasing dividends for at least the last five consecutive years. Many stocks on this list have paid increasing dividends for decades.
But while there are hundreds of potential dividend growth stocks to invest in at any given moment, the weekly “sales flyer” whittles the choices down to just those stocks that look like good buys at the current moment.
But what is a good buy?
Well, I like to think of a “good buy” as a high-quality dividend growth stock that appears to be undervalued.
The first thing you want to do is move beyond just that initial litmus test and really analyze a business.
What are the fundamentals like? What are the competitive advantages? What are the potential risks?
And then you have to actually take the time to figure out what a business is worth. After all, it’s impossible to know what you should pay for something if you have no idea what it’s worth.
Sure, you’re not a professional appraiser. I get that. Neither am I.
However, valuing high-quality dividend growth stocks isn’t a concept that’s all that difficult to understand.
In fact, there are numerous (free!) tools designed to help even a novice investor ascertain a good estimate of a stock’s intrinsic value.
One such tool is a valuation lesson put together by fellow contributor Dave Van Knapp.
Anyone can follow Mr. Knapp’s guidelines. This resource takes a concept that’s potentially complicated and makes it very easy to understand.
Buying a high-quality dividend growth stock when it’s undervalued confers many benefits to the long-term investor.
An undervalued dividend growth stock will likely offer a higher yield, greater long-term total return prospects, and less risk.
This is relative to what would be otherwise available if the same stock were fairly valued or overvalued.
It’s easy to see how this works.
First, price and yield are inversely correlated. That means a lower price will almost always equal a higher yield.
That higher yield is more income in an investor’s pocket today and, potentially, henceforth.
Of course, that also positively affects the potential total return, since yield is a major component of total return.
The other component is capital gain, and this, too, is positively affected by the very virtue of the upside that exists between the lower price paid and the higher worth of a stock.
If the market realizes that the stock’s mispricing led to a sale, it’s likely that the price rises back in line with value over the long term.
If not, you still have that higher yield to count on.
Lastly, the risk is lessened due to the margin of safety that’s attained when paying far less than what a stock is worth.
If you pay exactly what a stock is likely worth, you have no margin of safety. If the company does something wrong, or if your estimate is off, you could be upside down on your investment fairly quickly.
But if you, say, pay $40 for a stock estimated to be worth $50, you’ve got a comfortable margin of safety.
The company could make a wrong move and lower the value of the business by $1 or $2 per share, but you’d still ahead.
Plus, you’re paying less per share when you buy an undervalued stock. Paying fair value or, worse, more than fair value means you’re going to be paying more per share. That’s more money out of your pocket for every share you’re buying. If you have a static number of shares in mind, you’ll be risking less overall cash.
With all this in mind, let’s see what dividend growth stock is on this week’s “sales flyer”.
Qualcomm, Inc. (QCOM) develops and licenses products and services based on its advanced wireless broadband technology including semiconductors for mobile phones.
To be honest, technology is one of my least favorite industries to invest in.
However, technology is increasingly becoming prevalent in every business. Even staid consumer products companies are becoming more and more technologically advanced. So avoiding tech these days is just silly.
Moreover, there is a handful of high-quality, diverse, and cash-rich technology titans that sport excellent fundamentals, entrenchment, and ubiquity.
Qualcomm is one of these titans.
This company has leveraged its patents, expertise, and technology to the point of saturation – to great effect for its shareholders.
Qualcomm has licensing deals on its CDMA and OFDMA technology that allows the company to collect royalties on the majority of all 3G and 4G mobile phones sold in the world. Due to the massive IP that Qualcomm has, most handsets are essentially unable to connect to 3G networks without the licensing and royalties.
So if you want to talk about ubiquity, there you go.
But the days of high-flying dotcom businesses crashing in spectacular fashion are long gone.
Qualcomm is a stable company – with a growing dividend to prove it.
They’ve paid an increasing dividend to shareholders for 14 consecutive years.
And we’re talking sizable dividend growth here: the 10-year dividend growth rate stands at 18.5%.
I ordinarily see such substantial dividend growth reserved for stocks with low yields. After all, it’s basically the “holy grail” of dividend growth investing to get a stock with both a high yield and a high dividend growth rate.
Well, this stock might not be too far off: the current yield is sitting at 3.16%.
Almost never do you see a stock with a yield over 3% and a long-term dividend growth rate so high.
Furthermore, that yield is more than 100 basis points higher than the stock’s own five-year average. And it’s also significantly higher than the broader market.
Plus, the payout ratio is only 56%. So there’s plenty of room for more dividend raises.
Of course, in order to really have a good idea as to what to expect for dividend growth moving forward, we first must see what kind of underlying earnings growth the company is generating.
So we’ll take a look at Qualcomm’s top-line and bottom-line growth over the last decade. And then we’ll compare that to a near-term forecast for future earnings growth. Combined, this should give us a big-picture look at the company’s growth profile.
Qualcomm grew its revenue from $8.871 billion to $23.554 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 11.46%.
Meanwhile, they increased their earnings per share from $1.95 to $3.81 over this same period, which is a CAGR of 7.73%.
There’s been a slight margin compression over the last 10 years, but the company simply went from outstanding numbers to slightly less outstanding.
Looking forward, S&P Capital IQ believes that Qualcomm will compound its EPS at an annual rate of 3% over the next three years. They believe strong demand for high-end and mid-tier handsets will drive royalty growth. But that’s offset by regulatory concerns.
This seems like a very conservative prediction, considering Qualcomm’s long-term track record. In addition, Qualcomm’s pending acquisition of NXP Semiconductors NV (NXPI) is expected to be highly accretive to non-GAAP earnings immediately upon close.
Nonetheless, Qualcomm is operating at a high level. With a modest payout ratio and even just growth along the lines of their 10-year average, there’s a lot of potential for strong dividend growth here.
The rest of the company’s fundamentals are also impressive.
With a long-term debt/equity ratio of 0.31 and an interest coverage ratio of 24, the balance sheet looks really strong after an initial look.
However, that’s before considering that the total cash exceeds $18 billion. That’s more than twice the company’s long-term debt.
All in all, the balance sheet is stellar.
Profitability is also fantastic.
Over the last five years, Qualcomm has averaged net margin of 25.80% and return on equity of 18.07%.
Both numbers are great, both in absolute and relative terms. Although the margins have compressed a bit, there’s still a lot to like here.
With all that this stock offers, one might expect to pay a high price.
But I’d actually argue the stock looks fairly cheap here…
The stock is trading hands for a P/E ratio of 17.62 right now. That’s well below the broader market. More importantly, it compares very favorably to the stock’s own five-year average of 19.4. Every other basic metric I track is also significantly below its respective recent historical average. And the yield, as noted earlier, is much higher than its five-year average, too.
So it does look quite cheap. But how cheap? What might the intrinsic value be?
I valued shares using a dividend discount model analysis. I factored in a 10% discount rate. And I assumed a long-term dividend growth rate of 7%. This growth rate is well below the stock’s long-term EPS and dividend growth rates, respectively. With a modest payout ratio and an acquisition that is supposed to be highly accretive, this seems like a fair consideration. The DDM analysis gives me a fair value of $75.61.
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.
My analysis shows that this is a stock that is at least moderately undervalued. But my viewpoint is just one of many. Let’s see what some professional analysts think this stock is worth.
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 QCOM as a 3-star stock, with a fair value estimate of $72.00.
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 QCOM as a 4-star “BUY”, with a fair value calculation of $78.70.
So I came out right in the middle there. Averaging the three figures out gives us a final valuation of $75.44, which is just pennies away from my number. That appears to be a very reasonable estimate of this stock’s worth, which would imply that the stock is quite possibly 13% undervalued.
Bottom line: Qualcomm, Inc. (QCOM) is a high-quality company that has reliable royalty revenue, thanks to the company’s IP that gives it extensive licensing opportunities. And with the ubiquitous nature of 3G and 4G handsets, Qualcomm is in a great position. With a yield more than 100 basis points above its five-year average, and the potential for 13% upside, this stock offers dividend growth investors a solid opportunity to buy a stock with above-average yield and above-average dividend growth at a below-average price.
— Jason Fieber
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