Undervalued Dividend Growth Stock of the Week: Duke Energy Corp. (DUK)

I remember back when I still had a day job, there used to be these lottery pools.

Coworkers would get together and buy lottery tickets in bulk.

I never participated, as I never saw any logic in the activity. It seemed like a total waste of money to me.

You have a better chance of getting killed by lightning than winning a major lottery jackpot. 

Yet the irony and comedy of the matter became heightened when some of these same people saw my stock investing activity as “gambling”.

While buying a lottery ticket is literally the dictionary definition of “gambling”, buying slices of real businesses that produce real profits is pretty much the opposite of gambling.

Of course, as far as I know, nobody from my former workplace has won hundreds of millions of dollars.

However, my prudence, which dictated living below my means and intelligently investing my excess capital, led to what some might consider “lottery money”.

Indeed, my real-life and real-money dividend growth stock portfolio is valued at well into the hundreds of thousands of dollars, which is on par with what many large lottery prizes are.

Better yet, that portfolio generates the five-figure and growing passive dividend income I need to sustain myself in life, rendering me financially independent in my 30s.

So I essentially “won the lottery” without actually ever buying a ticket.

The crazy thing is, it’s actually quite simple to do this.

All I did was live frugally 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 – a compilation of more than 800 US-listed stocks that have paid increasing dividends each year for at least the last five consecutive years.

What this tells you is that you, too, can “win the lottery” without ever touching a lottery ticket!

Moreover, you have way better odds of actually succeeding when you’re directing capital toward high-quality investments rather than lottery tickets.

And helping you succeed toward that venture is exactly what today’s article is all about.

I’m going to highlight a high-quality dividend growth stock (sourced from Mr. Fish’s list) that appears to be undervalued…

Investing in a high-quality business (if the alternative is an average-quality or a low-quality business) should be an obvious choice.

But even a wonderful business can be a somewhat poor investment, especially over the short term, if an investor buys stock when the valuation is too high.

Price is what you pay, but value is what you get for your money.

If the former is well below the latter, however, this can lead to magnificent benefits for an investor.

That’s because an undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk. 

This is relative to what the same stock might otherwise present the investor if it were fairly valued or overvalued.

It’s easy to see how these benefits line up.

Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.

That higher yield should mean more current and ongoing passive investment income (on the same invested dollar).

And since these are dividend growth stocks we’re talking about, all future dividend raises will be based off of that higher starting yield, magnifying the effects of compounding and dividend growth.

Furthermore, since yield is one of two components of capital gain, you can likely count on greater long-term total return potential.

That total return potential is given another boost via the “upside” that exists between a lower price paid and a higher intrinsic worth of a stock, assuming it’s actually undervalued at the time of purchase.

While the market is generally fairly rational over the long run, price and value can wildly disconnect over the short term.

Well, any correction in that disconnect, which is the upside, can result in excess capital gain. Capital gain is, of course, the other component of total return.

And that “upside”, the capital gain, is on top of whatever possible organic capital gain that exists as a business naturally becomes worth more (increasing its intrinsic value) if/when it sells more products and/or services over time.

All of this has a way of reducing one’s risk, too, due to the margin of safety that should be present when price is well below value.

When upside is increased, downside is decreased. A margin of safety protects an investor’s interests, as it’s always possible that intrinsic value could be estimated too highly at the outset of investment, or a company becomes worth less (lowering its intrinsic value) due to any number of factors outside of an investor’s control.

Lacking a margin of safety means it’s easier for an investment to become “upside down” (worth less than an investor paid).

These benefits are incredible.

But what’s perhaps even more incredible is that valuing just about any dividend growth stock out there isn’t a complex task.

To make matters simpler, fellow contributor Dave Van Knapp put together a great guide to valuing dividend growth stocks.

Part of an overarching series of “lessons” on dividend growth investing, his article breaking down valuation is particularly relevant to today’s topic.

I’ll now reveal and discuss a high-quality dividend growth stock that looks undervalued at today’s prices…

Duke Energy Corp. (DUK)

Duke Energy Corp. (DUK) is a large US utility company, operating regulated utilities in the Carolinas, Indiana, Florida, Ohio, and Kentucky. They deliver electricity and gas to more than seven million customers.

Duke Energy operates in three segments: Electric Utilities and Infrastructure, 81% of FY 2017 total reportable segment income; Commercial Renewables, 11%; and Gas Utilities and Infrastructure, 8%.

Utility companies like Duke Energy have long been a favorite of dividend growth investors, especially older income-oriented investors who are closer to, or already, living off of their investment income.

That’s because utility stocks usually offer significantly higher yields than the broader market.

And due to the very nature of the business model, those dividends are about as reliable as they come.

Energy is ubiquitous. A consumer can’t just not have power. It’s a necessity in modern-day civilization.

And so a utility company’s income is practically guaranteed, which funnels down to the dividend.

Furthermore, utility companies operate local monopolies. You almost always have just one power company providing basic utilities to a particular area.

Combining a monopoly with a necessary service makes for a very appealing long-term investment idea.

However, utilities face regulation, limited or no geographic expansion opportunities, government limits on growth, and heavy spending on infrastructure.

That all said, a high-quality utility stock acquired at the right price can be a great fit in a diversified dividend growth stock portfolio.

And I think Duke Energy fits the bill right now.

First, let’s take a look at the dividend metrics.

Duke Energy has been paying a quarterly cash dividend on its common stock for 92 consecutive years.

And they’ve been increasing that dividend for 13 consecutive years.

The ten-year dividend growth rate isn’t terribly high; it’s currently sitting at 3.1%.

However, there has been a slight acceleration in that dividend growth in recent years. The most recent dividend increase, for example, was over 4%.

And that kind of dividend growth is actually quite respectable when you consider the stock yields a juicy 4.73% right now.

That yield, by the way, is more than 40 basis points higher than the stock’s five-year average yield.

Plus, I foresee more 4%+ dividend increases coming.

The payout ratio is sitting at 81.7%.

While seemingly a bit high, that’s right in line with what you see from a lot of utility stocks.

And with management targeting 4% to 6% growth through 2022, dividend growth could and probably will fall in that same range.

But in order to really build out a reasonable expectation for future dividend growth, which will help us later value the stock, we must first look at what kind of overall business growth the company is managing.

For that, we’ll first see what kind of top-line and bottom-line growth Duke Energy has generated over the last decade, which will serve as a proxy for the long haul.

While we invest in where a company is going (not where it’s been), knowing what a company has done over a fairly long period of time tells us a lot about what it might do going forward.

We’ll then compare the backward-looking growth with a forward-looking professional growth forecast.

Combining these numbers should give us a good idea as to where Duke Energy is going, which will help us estimate its intrinsic value.

Duke Energy has increased its revenue from $13.207 billion to $23.565 billion between fiscal years 2008 and 2017. That’s a compound annual growth rate of 6.64%.

This is fairly impressive for a staid utility. However, Duke Energy grew partly through acquisitions over this period. Namely, they acquired Progress Energy in 2012, and they later acquired Piedmont Natural Gas Co. in 2016.

The bottom-line growth is more accurate, as it factors in any dilution that occurred. While the top-line growth is measured in absolute terms, the bottom-line growth is measured in relative terms (on a per-share basis).

The company grew its earnings per share from $3.21 to $4.36 (after accounting for a 1-for-3 reverse stock split in 2012) over this same period, which is a CAGR of 3.46%.

So we see more modest bottom-line growth that’s more in line with what you’d expect from a utility.

Still, I don’t think there’s anything to be disappointed with here. The utility is growing at ~3.5% per year, which is combined with a 4.5%+ yield. And the company is guiding for an acceleration in bottom-line growth. Plus, this is all on a reliable business and dividend.

Overall, a lot to like here.

Looking forward, CFRA is forecasting a 4% CAGR in Duke Energy’s EPS over the next three years, which is on the low end of what the company’s management is targeting through 2022.

Even if they do come in on the low end of that target, landing at that 4% annual mark, that would allow for like dividend growth, which is right where the last dividend increase was.

But if the company can come in on the higher end, that could allow for even more dividend growth acceleration.

I’d keep my expectations conservative, but there’s a chance that the utility could deliver a pleasant surprise in regard to EPS and dividend growth over the next few years.

Said another way, the odds of them exceeding expectations seem greater than the odds of them doing worse than expectations.

Like most utilities, Duke Energy has a leveraged balance sheet.

The long-term debt/equity ratio is 1.17. And the interest coverage ratio is a bit over 3.

Also in consideration here is the fact that the balance sheet has relatively little cash on it.

In a vacuum, in isolation, this balance sheet is not very good. If this were another business in another sector, I’d be a bit concerned.

However, most utilities have similar balance sheets. And I’m not particularly concerned because of the very nature of the business model.

Their revenue and profit (and respective growth of both) is practically set in stone by the combination of the necessity of their services and the government’s role in putting forth acceptable profitability metrics (allowing for rate increases as growth projects are built out).

Society cannot currently function without utility companies, so a utility can comfortably operate with more leverage than most other companies in other industries can.

Profitability is roughly in line with what we should expect, but I think there’s some room for improvement here across the board.

Over the last five years, the company has averaged annual net margin of 10.63% and average return on equity of 6.16%.

This isn’t a stock that’s going to wow you with growth. It’s not going to revolutionize the way the world works. It’s not on the cusp of any kind of breakthrough.

But it’s a stock that’s going to pay you a sizable and reliable dividend that’s growing at a rate a bit above inflation.

And that dividend is backed by a business model that’s necessary, ubiquitous, and monopolistic.

While there are advantages and disadvantages to consider (as discussed earlier), there aren’t a ton of options out there if you’re looking for a rock-solid near-5% yield.

That’s especially true if you’re looking for a good deal on your shares.

Well, I think this stock has you covered there, as the valuation looks fairly appealing right now…

The P/E ratio is sitting at 17.28 right now, which is well below the stock’s own five-year average P/E ratio of 21.7.

That said, utilities (like Duke Energy) routinely register GAAP EPS that is affected by numerous non-cash issues. And so it’s sometimes difficult to compare P/E ratios.

Still, though, the company’s revenue is available at a multiple in line with the five-year average – and that’s in an expensive market.

Also, the stock’s current yield, as noted earlier, is markedly higher than its five-year average.

So if the valuation is appealing, how appealing might it be? What is a reasonable estimate of the stock’s intrinsic value? 

I valued shares using a dividend discount model analysis.

I factored in a 9% discount rate (due to the high yield) and a long-term dividend growth rate of 4%.

I think that DGR is actually conservative, due to the dynamics I went over above. If anything, Duke Energy is in a good position to exceed this mark.

But I think it’s always prudent to be cautious when modeling out dividend growth over the long haul. And what happens over the near term may be negatively impacted by what happens over the long term, meaning a long-term average may skew lower than a near-term average.

The DDM analysis gives me a fair value of $74.05.

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 concludes that the stock is roughly fairly valued.

However, as always, my analysis and valuation is but one of many looks at this stock, and I was arguably conservative.

Let’s see what a couple professional analysis firms think of the stock’s valuation here.

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 DUK as a 4-star stock, with a fair value estimate of $87.00.

CFRA 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.

CFRA rates DUK as a 4-star “BUY”, with a fair value calculation of $94.53.

I came out on the low end here. Averaging the three numbers out gives us a final valuation of $85.19, which would indicate the stock is potentially 13% undervalued right now.

Bottom line: Duke Energy Corp. (DUK) offers a business model that’s necessary, ubiquitous, and monopolistic. This high-quality dividend growth stock offers a big, reliable, and growing dividend. The near-5% yield is backed up by almost 100 years of quarterly dividend payments. Plus, you’re looking at the possibility that shares are 13% undervalued. Buying dividend growth stocks like this one could be like “winning the lottery” without actually buying a lottery ticket.

— Jason Fieber

Note from DTA: How safe is DUK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, DUK’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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