Imagine finding $20 on the ground.
You’d surely bend over to pick it up, right?
You’d feel elated, like the universe is smiling down on you.
As you probably should, since free money is always wonderful.
Now imagine finding $20 in your bank account regularly.
Except you don’t even have to expend the effort necessary to bend over to pick it up.
How awesome would that be?
Well, that’s essentially what collecting a dividend feels like.
As someone who is averaging a dividend payment every single day of the year, you can only imagine how I feel every single day I get up.
As a dividend growth investor who owns equity in over 100 high-quality companies that pay growing dividends, I average a dividend payment every day of the year.
So I feel like each day is an opportunity to “find” money I didn’t have the day before.
I’m basically finding (more than) $20 on the ground every day.
Dividend growth investing simply involves buying and holding stock in quality businesses that regularly increase their profit and directly share that increasing profit with shareholders in the form of a growing dividend.
It’s an investment strategy that has served me incredibly well, with the five-figure dividend income I earn covering a substantial portion of my personal expenses.
This situation allowed me to quit my day job a few years ago.
I’m now basically “retired” in my 30s, though I still choose to work and add value to the world and my life.
I worked hard, saved my money, and regularly invested intelligently to get here. That’s essentiallymy “blueprint” for early retirement.
The investing portion of that equation focuses on dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list – an amazing resource of more than 800 US-listed stocks that have all increased dividends for at least the last five consecutive years.
Dividend growth investing is great because it’s extremely intuitive.
One should naturally expect a portion of any profit a business that they own generates.
If you work for a business, you expect a paycheck. Well, it’s no different if you own that business.
In addition, a dividend forces management to be prudent with cash flow. A dividend is less money to waste.
Perhaps most important, a regular stream of dividends is a fantastic source of completely passive income.
You don’t need to call anyone to collect. You don’t need to hunt down your money. The dividends just show up.
But as great as this investment strategy is, one can’t just pick a random stock from Mr. Fish’s list and buy it at whatever price is prevailing.
One wants to make sure the business they’re investing in is a high-quality company, which can be determined after a full analysis of the fundamentals, qualitative aspects, and risks.
And perhaps just as crucial, one wants to pay a good price for the stock.
Just like with anything else you’re buying in your life, you don’t want to blatantly and knowingly pay far more than you should.
You don’t go around paying $10 for a loaf of bread.
Likewise, you don’t go around paying $50 for a stock worth $20.
That’s a recipe for disaster.
On the contrary, long-term investors should always aim to pay less than that which a stock is worth.
Price is simply what you’re paying.
But value is what something is worth.
Value gives context to price.
Value tells one whether or not price is appropriate.
Insofar as dividend growth investing is concerned, undervaluation is what one should aim for with every stock they’re interested in buying.
Undervaluation is present when price is less than value.
And it’s appealing for a variety of reasons.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk.
That’s all relative to what the same stock would otherwise offer if it were fairly valued or overvalued.
Price and yield are inversely correlated. That means, all else equal, a lower price will result in a higher yield.
That higher yield gives one’s potential long-term total return a big boost, as the dividends/distributions a stock pays is one of two components of total return.
The other component is capital gain, and capital gain is also given a potential boost via the upside that exists between the price paid and the fair value of an undervalued stock.
If a stock is worth $50 but you pay $40, there’s $10 worth of upside that the market could very well recognize over time. That’s on top of whatever natural appreciation occurs as the business sells more products and/or services, which increases its value.
While the stock market isn’t a very good gauge of value over the short term, price and value do tend to roughly converge over the long haul.
Paying less should also reduce one’s risk.
A margin of safety is generally introduced when undervaluation is present, as the gap between price and value provides a “buffer” of sorts.
That previous example includes $10 worth of buffer.
So in case something goes wrong with the business or investment thesis, the valuation could actually drop quite a bit before the stock is worth less than you paid.
While it might seem like a difficult prospect to estimate value and find undervalued dividend growth stocks, it’s not actually all that hard at all.
There are a number of resources designed to help investors with this task.
One such resource is freely available right here on the site.
Fellow contributor Dave Van Knapp put together a series of lessons on dividend growth investing.
One of those lessons focuses specifically on valuation, and it’s a great tool to learn from and refer back to.
All of this information is fantastic, but I’m going to take it a step further by putting it all to work – and showing you readers what a high-quality dividend growth stock looks like when it looks undervalued in real-time.
Magna International Inc. (MGA) is a global automotive supplier that designs, develops, manufactures automotive systems, parts, assemblies, and modules for car and light truck original equipment manufacturers. Operations span 29 countries, and they’re the most diversified automotive supplier in the world in terms of product offerings.
Magna is one of the more interesting businesses I follow, write about, and invest in.
I say that because the company has a “corporate constitution” that entitles shareholders of common stock to dividends that amount to at least 10% of Magna’s after-tax profits for the corresponding financial year.
While that won’t help if Magna registers a loss, it does provide a bit of a written “floor” to the dividend that doesn’t exist for just about every other company I’m aware of.
And to provide some protection to its profit, Magna is incredibly diversified across both manufacturers and countries, so that Magna is not overly reliant on any one geographical location or manufacturer.
All of this has worked to the benefit of Magna’s shareholders for years.
Indeed, the company has increased its dividend for seven consecutive years. And they have a track record for paying dividends stretching back decades.
While the Great Recession, which was one of the worst financial disasters in generations, greatly hampered the business, they’ve bounced back strongly.
That recovery shows up in its dividend growth rate: Magna’s five-year dividend growth rate stands at 14.9%.
And with a payout ratio of just 20.1%, there’s still plenty of room for more dividend increases to stream in.
For reference, they just increased their dividend by 10% back in February, so double-digit dividend growth continues.
The only real drawback here might be the yield.
At 2.49%, there’s probably something to be desired there.
However, that’s still higher than the broader market. And it’s certainly much greater than anything the local bank will provide.
Moreover, it’s 60 basis points higher than the stock’s own five-year average.
So we can see that dynamic between undervaluation and higher yield playing out here.
But in order to determine what to expect in terms of future dividend growth, we’ll want to see what kind of underlying operational growth the company is managing.
So we’ll next see what Magna has done over the last decade (which is a pretty good proxy for the long term) with its revenue and profit.
We’ll then compare that 10-year top-line and bottom-line growth to a near-term forecast for profit growth.
Combining long-term growth with a future forecast should give us a pretty good idea as to what to expect from Magna in terms of profit expansion moving forward, which will tell us a lot about what kind of baseline expectation to form regarding dividend growth.
All of this will also help immensely when the time comes to value the business.
Magna’s revenue is up from $26.067 billion to $36.445 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 3.79%.
Meanwhile, earnings per share increased from $1.47 to $5.16 over this same period, which is a CAGR of 14.97%.
We now see where some of that huge dividend growth came from: the company’s profit over the last decade has increased very nicely.
However, the company registered a loss in FY 2009. And the dividend was subsequently cut rather dramatically.
So that’s something to keep in mind.
In addition, a combination of share buybacks and margin expansion led to the disparate growth between the top line and bottom line. I find it unlikely that favorable combination will continue to that degree going forward.
Nonetheless, S&P Capital IQ believes Magna will be able to compound its EPS at an annual rate of 17% over the next three years, which would be a notable acceleration from what Magna has done over the last decade.
While that would be a feat, coming anywhere close to that would be an excellent result for Magna and its shareholders.
In addition to an excellent growth profile, Magna also sports a fantastic balance sheet.
The company’s long-term debt/equity ratio is 0.25, while its interest coverage ratio is over 32.
Profitability is among the best in the industry, especially after the aforementioned margin expansion that’s occurred over the last decade.
Over the last five years, Manga has averaged net margin of 5.18% and return on equity of 19.43%.
The fundamentals are impressive across the board.
You’ve got great top-line, bottom-line, and dividend growth. A strong balance sheet. Robust profitability.
And this is one of the largest and most diversified businesses in its industry, a true leader pretty much across the board.
You’d think the premium quality would deserve a premium valuation, but I’d argue the valuation is actually quite appealing right now…
The stock is trading hands for a P/E ratio of just 8.07 right now. That’s less than half the broader market. It’s well below the industry. And it’s also a significantly below the stock’s own five-year average P/E ratio of 10.8. Most other basic metrics are below their respective recent historical averages. And the stock’s yield, as noted earlier, is much higher than its own five-year average.
So it looks like a higher-than-average stock at a below-average valuation, but what might the intrinsic worth of the stock actually be?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 8%.
If you look at past profit growth, expected future profit growth, the low payout ratio, and the demonstrated dividend growth, an 8% expectation isn’t really that aggressive here.
The DDM analysis gives me a fair value of $59.40.
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 valuation analysis estimates the intrinsic value of this stock as being much higher than its current price, indicating strong undervaluation. But let’s see my estimate compares to what some professional analysts have concluded.
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 ranks MGA as a 4-star stock, with a fair value estimate of $55.00.
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 ranks MGA as a 5-star “STRONG BUY”, with a fair value calculation of $55.20.
So we see a pretty tight consensus here, adding weight to the thesis. If we average out the three numbers, we get a final valuation of $56.53. That would indicate the stock is 28% undervalued.
Bottom line: Magna International Inc. (MGA) is a global, diversified behemoth that is operating at a very high level. The broader market is near all-time highs, yet this stock is trading well below its recent historical averages. With an attractive yield and the potential for 28% upside, this dividend growth stock could be an excellent long-term investment.
— Jason Fieber
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