Undervalued Dividend Growth Stock of the Week: Realty Income Corp. (O)

If someone asks you what you do, imagine coming back with this answer:

Investor.

Sounds pretty fancy, doesn’t it?

Well, maybe it is. Maybe it is fancy to be an investor.

Or perhaps that’s just perception.

The funny (and great) thing about it is, it’s not difficult to become an investor.

You simply have to save up some capital and then put that capital to work through investments.

Anyone can become an investor. Anyone can put capital to work with wonderful businesses and grow their wealth and passive income.

It used to be (just a couple decades ago), you had to save up thousands of dollars for large blocks of stock, make a call to your broker, and then pay really high commission fees for the privilege.

But that’s not the case any longer.

Anyone can save up a little money, open an online brokerage account, buy stock in great companies, and pay very little (or nothing) in commission fees.

While it’s up to you to save that money and take those steps, it’s up to us to provide you with great long-term investment ideas for your capital.

And that’s what today’s article is all about.

The idea I’m going to present is a high-quality dividend growth stock that appears to be undervalued.

The reason it’s a dividend growth stock is quite simple.

Dividend growth stocks are often blue-chip stocks because of the very nature of growing dividends. 

Let me explain.

A lengthy track record of dividend growth is usually a pretty good litmus test for business quality, as it’s nigh impossible to run a low-quality business while simultaneously paying out ever-larger dividends to your shareholders.

You can see what I mean by perusing David Fish’s Dividend Champions, Contenders, and Challengers list, which has compiled invaluable data on more than 800 US-listed stocks that have all raised their dividends each year for at least the last five consecutive years.

You’ll notice numerous blue-chip stocks on Mr. Fish’s CCC list. These are global firms that dominate their respective industries.

And I’m invested in a number of them myself: my FIRE Fund, which is my real-life and real-money dividend growth stock portfolio that allows me FI/RE (financial independence/retired early), is comprised of more than 100 different stocks, with most of them being high-quality dividend growth stocks that can be also found on Mr. Fish’s list.

My FIRE Fund generates the five-figure and growing passive dividend income I need to sustain myself in life.

To get to this spot, I simply decided to “become an investor” – saving my money and then intelligently investing that capital into great businesses.

Dividend growth investing has always struck me as one of the most intelligent investment strategies of all.

And it’s worked out tremendously well.

Dividend growth investing has literally changed my life, allowing me financial freedom in my early 30s.

But as great as this strategy is, you want to make sure you’re buying high-quality dividend growth stocks when they’re undervalued.

The high-quality part might seem obvious – looking for strong fundamentals, durable competitive advantages, and minimal operational risks should clue you in.

But the undervaluation part might be a bit less obvious.

However, it’s an imperative aspect of long-term investment success.

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

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

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

That higher yield means more investment income, which is great in and of itself. Nobody likes less passive investment income.

But it also gives potential total return a boost due to the fact that total return is comprised of investment income (dividends or distributions) and capital gain.

We can see how the former (investment income) is positively affected by undervaluation.

But the latter (capital gain) is also positively affected by virtue of the “upside” that exists between a lower price paid and higher intrinsic value of a stock (assuming it is undervalued).

The stock market might not accurately price stocks over the short term. That’s due to the emotional responses embedded in the market, as the market has a lot of humans buying and selling stocks.

But the market tends to more appropriately price stocks over the long run, roughly matching price and value.

If you’re able to take advantage of any short-term mispricing, you could be looking at a lot of capital gain as that stock behaves like a coiled spring – and that’s on top of whatever capital gain is possible as a business naturally becomes worth more (as it increases its profit over time).

These dynamics should also reduce risk.

It follows logic that more upside is less downside.

Undervaluation should provide an opportunity to build in a margin of safety, which protects an investor against being “upside down” on an investment in case the business does something wrong or somehow performs unexpectedly.

When valuing a stock, you’re making a lot of assumptions about the future.

And that’s why you want to be cautious and conservative about that when it comes time to value and buy a stock.

Fortunately, fellow contributor Dave Van Knapp has put together an excellent piece on exactly how to go about doing that.

It’s his “lesson” on valuing dividend growth stocks, which is part of an overarching series of lessons on dividend growth investing as a whole – these lessons describe what dividend growth investing is, why it’s so great, and how to successfully implement it.

What I’m now going to do is put this all together for you readers.

I’m going to highlight a high-quality dividend growth stock that appears to be undervalued at current prices…

Realty Income Corp. (O)

Realty Income Corp. (O) is a real estate investment trust that leases freestanding, single tenant, triple-net-leased retail properties.

Their portfolio of over 5,000 properties is spread out across 49 states and Puerto Rico. They lease to almost 250 different tenants. They’re exposed to 47 different industries.

Realty Income is one of the most reliable REITs out there, especially for dividend growth investors.

That’s due partly to the business model.

The REIT is incredibly diversified, which has helped serve them well over the years.

And the way their triple-net leases work is this: it means the tenant is responsible for net building insurance, net common area maintenance, and net real estate taxes on the leased asset.

That insulates Realty Income from a lot of responsibilities/issues, but they’re still able to collecting those rising rent checks.

And those rising rent checks are essentially passed down to the shareholders via regular and growing dividends.

That means buying stock in Realty Income basically turns you into a commercial real estate owner/landlord, without going through all of the rigmarole that would ordinarily be involved if you were to try to go at it alone.

Furthermore, you’re instantly diversified, with a great management team going to work for you.

Getting back to those rising dividend checks, you can look forward to collecting them monthly.

That’s because Realty Income pays a growing, monthly dividend.

In fact, they’ve marketed themselves as the The Monthly Dividend Company® for good reason: they’ve paid out 572 consecutive monthly dividends.

And it isn’t just that reliable and regular stream of income shareholders look forward to; the company is regularly increasing its dividend, too.

In fact, they’ve increased their dividend for 25 consecutive years – ever since going public in 1994.

And the 4.4% 10-year dividend growth rate is made to be quite impressive when you consider the stock currently yields a massive 5.02%.

That yield, by the way, is more than 30 basis points higher than the stock’s own five-year average yield.

The payout ratio, though, is just a touch high – sitting at 93.4%.

All in all, future dividend growth might slow a bit relative to the 4.4% it’s averaged over the last decade.

But when you’re starting out with a yield over 5%, you don’t need a ton of dividend growth to make the numbers work.

Let’s dig into the company’s growth over the last decade, which should help us build some expectations for future dividend growth.

These expectations will also help us value the business and its stock.

I’ll first show you readers what Realty Income has delivered in terms of top-line and bottom-line growth over the last ten years (using that as a proxy for the long term). And then we’ll compare that to a near-term professional forecast for profit growth.

Blending the known past and estimated future in this fashion should allow us to home in on what kind of overall business growth Realty Income is capable of, which should more or less translate into dividend growth.

Realty Income grew its revenue from $331.7 million in fiscal year 2008 to $1.216 billion in FY 2017. That’s a compound annual growth rate of 15.53%.

A blistering top-line growth rate for sure.

However, REITs (like Realty Income) routinely issue equity in order to fund growth; that portfolio of properties doesn’t get built out of thin air. So there’s an ever-expanding balance sheet and share count to keep in mind.

That’s why it’s better to look at growth in relative terms, on a per-share basis, which accounts for the increase in shares.

Furthermore, a REIT cannot be analyzed by looking at EPS due to the unique business structure.

Extremely high amortization and depreciation expenses can distort a REIT’s true cash generation ability.

So we use what is called funds from operations or adjusted funds from operations as a measure of profit for a REIT. This is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.

Looking at this on a per-share basis, FFO/share increased from $1.83 to $2.82 over the last ten fiscal years, which is a CAGR of 4.92%.

Pretty consistent with the dividend growth rate over the same time period, but the payout ratio (which is a bit elevated right now) would indicate that dividend growth over the next year or two might be more subdued.

For further perspective on this expectation, CFRA believes Realty Income will compound its FFO/share at an annual rate of 4% over the next three years.

This isn’t too far off from what’s transpired over the last decade.

The company’s balance sheet, meanwhile, remains strong.

They have $6.7 billion in liabilities against $14 billion in assets.

Furthermore, Moody’s raised the credit rating of Realty Income to A3 in the fourth quarter of 2017. This is well into investment-grade territory.

The Monthly Dividend Company® is keeping true to its moniker – they just keep on pumping out those monthly (rising) dividends, which are funded by the monthly (rising) rent checks they’re collecting from their properties.

If you fancy yourself as not just an investor, but a landlord who collects rent monthly, Realty Income is one of the best ways you can accomplish both simultaneously – they send you your monthly rent check, but you don’t have to deal with the proverbial “leaking toilet”.

With a property portfolio that is incredibly diversified – spread out across more than 5,000 properties – and with an occupancy rate of 98.4% at the end of FY 2017 (matching their highest year-end occupancy rate in the last 10 years), this REIT (and its monthly dividend) is practically bulletproof.

Some of their largest tenants include fairly bulletproof companies of their own right: Walgreens Boots Alliance Inc. (WBA) and FedEx Corp (FDX) are their two largest tenants.

And all of this is available at what looks like an attractive valuation…

Looking at the price against FFO/share, we’re coming in at a ratio of 18.60.

That’s about as close to a traditional P/E ratio as it gets – and it looks fairly appealing in this market.

Every basic valuation metric is below its respective recent historical average.

And the yield, as noted earlier, is higher than its five-year average.

So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic look like? 

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 4.5%.

While near-term dividend growth might slow a touch (because of an elevated payout ratio), we can see that Realty Income has painted a very consistent picture – both the long-term FFO/share growth and dividend growth are coming in at at that mid-4% mark, and I don’t see that changing much going forward.

The DDM analysis gives me a fair value of $61.07.

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 I believe we’re looking at a high-quality business trading for a noticeable discount, but my viewpoint is but one of many.

Let’s compare my valuation to what two select professional analysis firms have come up with, which will add depth and perspective to the conversation.

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 O as a 4-star stock, with a fair value estimate of $59.00.

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 O as a 3-star “HOLD”, with a fair value calculation of $48.62.

The latter firm has a 12-month target price of $55.00, so there’s a slight disconnect. Using that TP would show more consistency across the viewpoints. Nonetheless, averaging out the three numbers gives us a final valuation of $56.23, indicating the stock is potentially 7% undervalued right now.

Bottom line: Realty Income Corp. (O) is a high-quality REIT that lives up to its moniker of The Monthly Dividend Company®. Their portfolio of properties is diversified, almost completely occupied, and enviable. With 25 consecutive years of dividend growth, a yield over 5%, the possibility that shares are 7% undervalued, and the ability to collect “monthly rent checks” without having to actually go out and do the hard work typically involved with being a landlord, this is a stock that should be on every dividend growth investor’s radar right now.

-Jason Fieber

Note from DTA: How safe is O’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 65. 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, O’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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