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

It’s easy to take living in a developed country in the year 2017 for granted.

But living in the United States in modern times is an unbelievable gift.

Just imagine being anyone else, anywhere in the world, even just a couple hundred years ago.

Even presidents and kings couldn’t get their hands on modern accoutrements like a smartphone, the Internet, and air conditioning.

One of my favorite benefits of living in the US in 2017 is easy access to the stock market.

One can open up a brokerage account online, fund it with a few bucks, and buy stock in a great business.

In minutes flat, no less.

You can literally start to change your life with a few bucks in just a few minutes.

Indeed, access to high-quality stocks has never been easier or cheaper.

But you have to take advantage of it.

I’ve taken advantage of this over and over again since I started investing back in mid-2010, going from below broke to essentially financially independent in the process.

Consistent saving and investing has resulted in a real-life six-figure portfolio that generates five-figure passive dividend income for me.

Nothing I did was particularly hard. In fact, the harder thing to do would have been to not save and invest over the past seven years.

I lived below my means. And I invested my excess cash flow into high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish’s list contains invaluable information on more than 800 US-listed stocks that have all increased dividends for at least the last five consecutive years.

Dividend growth investing is the strategy I’ve used to generate massive wealth and income in a short period of time.

And it’s a great strategy for this because of the very nature of the strategy.

When you buy a high-quality dividend growth stock, you’re simply investing in a business that directly rewards its shareholders with a slice of its growing profit.

I mean, why would anyone want to invest in a company that isn’t growing profit?

And why would a business that’s growing its profit not share a slice of that growing profit with its owners?

A great business should be able to sell more of its products and/or services to more people regularly, increasing its profit, which then makes the business worth more. As it becomes worth more, your investment value, of course, rises.

And as the profit grows, so should your dividend income. This growing dividend income, by the way, is totally passive. And it’s probably growing faster than inflation, assuming you’re investing in a wonderful business.

All in all, I don’t know of a better strategy for growing both wealth and income at such an appealing rate.

But as great as high-quality dividend growth stocks can be, one shouldn’t buy any dividend growth stock at any price.

One should first perform a full quantitative and qualitative analysis on any prospective business beforehand, so as to make sure the stock makes sense for long-term investment.

You should understand the business, You want great fundamentals. You should see solid competitive advantages. And you should take on as little risk as possible.

Perhaps just as important as finding the right business, you should make sure to pay the right price.

But paying the right price requires knowing information that has nothing to do with price.

That information is value.

Price only tells you how much something costs.

Value tells you what you’re receiving in exchange for your money. Value gives context to price. Value tells you what you’re actually paying.

You don’t go around paying much more than you should for everything in your life, do you?

Of course not.

Likewise, you don’t want to pay more than you should for a stock.

In fact, it’s quite the opposite: one should always aim to buy a high-quality dividend growth stock when it’s undervalued.

Undervaluation is present when a stock is priced less than it’s worth.

And undervaluation is very advantageous to the long-term dividend growth investor for a number of reasons.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return, and less risk.

This is all relative to what the same stock would offer if it were fairly valued or overvalued.

All else equal, a lower price will result in a higher yield.

That’s because price and yield are inversely correlated.

If a stock that’s fairly valued at (and priced at) $50 were to drop to $40, its yield would correspondingly rise.

That higher yield positively impacts both income and total return.

Your income (both in the current sense and the long-term sense) is given a boost by virtue of the higher yield you lock in when you buy.

But total return also benefits by virtue of that additional income, as total return is simply comprised of capital gain and income.

Not only that, but one’s long-term total return is also potentially increased due to the upside that exists between the lower price paid and the higher intrinsic value of a stock.

While the stock market isn’t necessarily very good at appropriately pricing stocks relative to fair value over the short term, price and value tend to often converge over longer periods of time.

Undervaluation can also reduce one’s risk, as a margin of safety is generally provided for when a favorable “buffer” exists between price and value.

The future is obviously impossible to predict. When you invest in a company, a lot of things can go wrong.

Well, it would thus make sense that you don’t pay too much for your stock, as that doesn’t give you any wiggle room for certain inevitable circumstances.

With all of the possible benefits that undervaluation confers to the long-term dividend growth investor, one would think that valuing dividend growth stocks is this extremely difficult task reserved for only a few.

Well, that aforementioned easy and cheap access to stocks plays out once more when it comes time to actually value a stock before investment.

A great example of this is a fantastic free resource available right here on the site.

Written by fellow contributor Dave Van Knapp, it’s a valuation guide for dividend growth stocks that makes the process of valuing almost any dividend growth stock out there pretty straightforward.

But I won’t just leave it there for you readers.

I’m going to show you what the application of some of these principles looks like in real-time…

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

This is one of my favorite businesses in the world. The depth and quality of Walt Disney is amazing.

Walt Disney is such a great company, that many of its subsidiaries could be wonderful businesses all by themselves.

You have the theme parks. Think Walt Disney World, Disneyland Park, Shanghai Disney Resort, and Disneyland Paris.

You have the television side. ESPN, ABC, and countless affiliates.

The movie franchises are money-making machines. Lucasfilm and Marvel Studios alone put out billion-dollar movies regularly. And that’s before even talking about standouts like Frozen, Beauty and the Beast, and Zootopia.

Plus, Walt Disney is the best in the business at cross-promoting its intellectual property. They’ll introduce a character via one media platform, and the next thing you know that character shows up in parks, merchandise, and other media platforms.

While many are focused on the potential issues surrounding ESPN (Media Networks accounts for almost half of Walt Disney’s revenue) and how cord-cutting will impact ESPN’s subscriber base (and the advertising revenue ESPN can generate), the fact remains that Walt Disney continues to grow its revenue and profit year in and year out, and the company continues to become more diversified every year.

One end result of all that continuous growth is an increasing dividend.

Walt Disney has increased its dividend for seven consecutive years.

Although Disney actually has a rich history regarding paying dividends to shareholders, the company’s decision to keep the dividend static during the Great Recession cuts its overall track record short.

Lest you think they’re not serious about handing out bigger dividends to shareholders every year, consider that the five-year dividend growth rate for the stock stands at a monstrous 30.1%.

CaptureSo they’ve made up for lost ground in a big way.

And with a payout ratio of 27.2%, there’s still plenty of room for more dividend growth for years to come.

The only real drawback to the dividend metrics, in my view, is the yield.

At just 1.44% there’s a lot to be desired there in terms of generating current income from the stock.

While the extraordinary dividend growth will lead to strong aggregate income over a longer period of time, anyone needing income from their investments today will be disappointed by this stock.

That said, the five-year average yield for the stock – even after accounting for the huge dividend growth – is just 1.3%, meaning investors buying the stock today are fortunate enough to lock in a yield higher than what investors have typically been able to get, on average, from this stock over the last five years.

With the quality and diversification of the business, strong dividend growth is likely to continue for the foreseeable future.

However, in order to form a baseline expectation for future dividend growth, we must first look at what kind of overall underlying growth the business is generating. And we also need to consider what kind of underlying growth the company might generate over the near term.

Combined, this should give us an idea as to what to expect from Walt Disney going forward.

In addition, it will greatly aid us when the time comes to value the business and its stock.

So we’ll first take a look at what Walt Disney has done over the last decade in terms of top-line and bottom-line growth, and then we’ll compare that to a three-year forecast for EPS growth.

The company increased its revenue from $35.510 billion to $55.632 billion over the period spanning fiscal years 2007 to 2016. That’s a compound annual growth rate of 5.11%.

About what I’d expect from a relatively mature company (Walt Disney’s market cap is north of $170 billion).

However, the company drove excess bottom-line growth by buying back shares and improving its margins.

The outstanding share count is down by just over 23%. And margins are up massively now compared to where they were 10 years ago.

Over the same 10-year period, the company’s earnings per share grew from $2.25 to $5.73, which is a CAGR of 10.95%.

We’re talking double-digit bottom-line growth for a large, mature company, which should also support double-digit dividend growth over the foreseeable future (especially after factoring in the low payout ratio).

Moreover, the growth was mostly secular. Profit took a dip in the Great Recession, which is true for almost every company out there. However, Walt Disney bounced back quickly. And it’s been uphill ever since.

For perspective, S&P Capital IQ expects Walt Disney to compound its EPS at an annual rate of 9% over the next three years, which isn’t too far off from what the company did over the last decade.

All in all, the growth is excellent. Even with the ESPN noise, Walt Disney just keeps chugging along.

But the excellent fundamentals don’t stop there.

Walt Disney’s balance sheet is also in great shape.

The long-term debt/equity ratio is 0.38, while the interest coverage ratio is over 40.

Profitability is robust, and it’s only improved as of late (relative to where it was 5-10 years ago).

Over the last five years, the company has averaged net margin of 15.06% and return on equity of 17.17%.

Walt Disney is, in my view, almost the very definition of quality.

They’re widely diversified in terms of offerings, audiences, and geography. The fundamentals are excellent. There’s no near-term threat to the overall business model.

And perhaps most notable for dividend growth investors, the dividend growth potential is outstanding.

Yet the stock appears to be fairly cheap right now…

The stock trades hands for a P/E ratio of 18.85. That’s below the broader market. And it’s also below the stock’s own five-year average P/E ratio of 19.6. Investors are also paying less for Walt Disney’s cash flow than they have, on average, over the last three years. And as shown earlier, the current yield is higher than the stock’s recent historical average.

So the company is more profitable than ever, yet the valuation is well off of recent averages. But how cheap might the stock be? What might it be intrinsically worth?

I valued shares using a two-stage dividend discount model analysis (to account for the low yield/high growth).

I factored in a 10% discount rate. I assumed a dividend growth rate of 18% for the first decade.

And then I assumed a long-term dividend growth rate of 7% thereafter.

That growth is on the aggressive side, but Walt Disney’s low payout ratio, double-digit demonstrated EPS and dividend growth over the last decade, and forecast for double-digit EPS growth over the next three years means they can certainly live up to these expectations.

The DDM analysis gives me a fair value of $135.70.

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 analysis shows that this stock is undervalued. But how does that analysis compare to what professional stock analysts have come up with?

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 $115.70.

So I came in right in line with Morningstar. All three models indicate undervaluation, however. If you average the three numbers out, you get a final valuation of $128.47. That would mean this stock is potentially 19% undervalued.

DIS_chartBottom line: Walt Disney Co. (DIS) embodies my definition of what a high-quality company looks like. As a result, it’s one of my favorite dividend growth stocks. The stock admittedly isn’t as cheap as it was the last time I wrote about it. But with the potential for 19% upside, this is one of my best long-term dividend growth investment ideas.

– Jason Fieber

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