What’s the difference between underpaying and overpaying for stock?

Well, the answer is money.

Perhaps a lot of it.

And since most people like to keep more of that green stuff in their pocket, it behooves one to always attempt to buy high-quality stock for less than it’s actually worth.

But how do we do such a thing?

[ad#Google Adsense 336×280-IA]The first thing one has to do is decipher the difference between price and value.

Stock quoting services are very, very good at telling you the exact price of a stock, live as of that moment.

But does that really tell you much of anything at all?

Not really. Price just tells you how much cash you have to shell out for a share of a company.

Price tells you how much something costs. It tells you how much you’re going to pay.

All fine and dandy, as you need to know how much money something is going to cost you.

But you need to know way more than that if you’re going to be a successful investor.

You specifically need to understand value. Value tells you what something is worth. Value tells you whether or not that price is fair or not. Value gives context to price.

Without value, price is practically meaningless.

Imagine a world with prices, but no idea of value. What would the numbers mean?

In a world like that, things could cost whatever. Bread could be $100 per loaf. A used sedan could cost $1 million. Without some semblance of value, prices have no anchor to reality.

The good news is that it’s not all that difficult to value stocks.

There are a number of different ways to go about valuing a business – and its stock – and I personally like to mix and match a few different approaches so as to narrow intrinsic value down a bit. But a system that’s freely accessible to you readers right here on the site, discussed by Dave Van Knapp, is definitely worth a look if you haven’t honed your own system yet.

What I like to do is first find a high-quality dividend growth stock.

You can find a number of them on David Fish’s Dividend Champions, Contenders, and Challengers list, which contains information on more than 700 US-listed stocks that have all increased their dividends for at least the last five consecutive years.

As far as resources on dividend growth stocks go, this is about as invaluable as it gets.

So I like to scan Mr. Fish’s list for high-quality dividend growth stocks, which aren’t hard to find with such a broad cross-section of the economy represented there.

But then I like to value what I find to make sure I’m paying a fair price or less.

Paying less than fair value first increases the yield on my investment since price and yield are, all else equal, inversely correlated.

Second, it reduces my risk. If I instead overpay, I’m working against the odds that the market will at some point recognize that mispricing and reprice that stock accordingly, causing me to suffer a capital loss in the process.

Third, it increases my potential long-term total return. One’s long-term total return is made up of two components: yield and capital gain. By increasing your yield right off the bat, you’re already improving your total return prospects. And by buying undervalued stocks, you’re increasing the odds that a repricing will work out in your favor, instead of against.

As such, you can imagine why I’ve done my best to be extremely vigilant when it comes to buying undervalued dividend growth stocks that also exhibit high amounts of quality for my personal portfolio.

But what I also do is I share my results. I find these high-quality dividend growth stocks trading at prices that appear to be below their actual intrinsic values, and then I share those names with you readers.

You ready?

CenterPoint Energy, Inc. (CNP) is a public utility holding company that owns a variety of energy-related businesses including electric transmission & distribution, natural gas distribution, and approximately 55% of Enable Midstream Partners LP (ENBL).

This is a really interesting utility investment.

First off, they lack the traditional electricity generation exposure, which could be a tailwind with prevailing trends toward heavy investment in clean energy generation.

In addition, their ownership of Enable Midstream gives them a nice growth kicker that many other utilities lack. Enable Midstream is a midstream pipeline partnership that encompasses over 21,000 miles of interstate, intrastate, and gathering pipelines in the Mid-Continent region, as well as natural gas processing and storage facilities.

And their unique structure has in part allowed them to increase dividends to shareholders for the past 10 consecutive years.

Not only do they have that budding track record, but management guidance routinely mentions dividend growth as a goal: Recent guidance called for 4% to 6% annual dividend growth for the foreseeable future, in line with targeted EPS growth.

That’s more or less in line with recent dividend increases, although it’s lower than the 10-year dividend growth rate of 9%.

cnpHowever, dividend growth over the last decade has outstripped EPS growth, leading to an elevated payout ratio of 81.1%.

While many utilities sport higher payout ratios, this is elevated beyond even what’s normal for the industry. As such, the guidance makes sense.

But while 4% to 6% dividend growth guidance might not be all that exciting for a stock yielding 2% or 3%, CNP yields a monster 5.29% right now.

Not only is that yield exciting from the standpoint of being high in a low-rate environment, but it’s also more than acceptable when it comes with a 4% to 6% growth trajectory. Moreover, and central to the thesis of this stock being undervalued, it’s much higher than the five-year average yield of 4.1% for CNP.

I really like the dividend story here. You’re getting a yield much higher than the broader market (more than twice as high), with solid dividend growth guidance, and a payout ratio that doesn’t indicate immediate danger of a cut.

But let’s take a look at underlying revenue and profit growth. Without that, the dividend growth will eventually die. And if the company isn’t growing, we might not have much of an investment at all here.

The last decade of top-line and bottom-line growth will tell us a lot about where CenterPoint might be going, and it’ll surely give us some of the tools necessary to value the business.

First up, revenue. More or less flat over the last decade, revenue is down slightly from $9.722 billion to $9.226 billion from fiscal years 2005 to 2014.

One aspect of utilities that I view as unfavorable for long-term investment is the cap on potential revenue growth due to heavy regulation, and I find revenue growth across the entire industry to be challenging.

Nonetheless, CenterPoint was able to grow profit at a fairly healthy clip – earnings per share increased from $0.75 to $1.42 over this 10-year stretch, which is a CAGR of 7.35%.

This is a rather impressive growth rate, especially for a utility, due to the aforementioned regulation and the fact that the outstanding share count has increased by almost 29% over this period.

S&P Capital IQ, however, anticipates slightly negative growth for EPS over the next three years, which would, if realized, be a significant divergence from CenterPoint’s guidance. Potential headwinds include lower commodity prices, but there is a lot of upside in the forms of cash distributions from its partnership and rate base growth. The truth might lie somewhere in the middle here.

As expected for a utility, CenterPoint does operate with somewhat heavy leverage. The long-term debt/equity ratio is 1.76 and the interest coverage ratio is just under 3.

CenterPoint has operated with this kind of debt load for some time now, so it’s not immediately concerning. Moreover, most utilities operate with somewhat significant debt due to the capital-intensive nature of the business model. Infrastructure requires these businesses to be heavily reliant on expensive, but long-life assets that are nearly impossible to replicate. And that’s where a lot of the value is.

Profitability is more than suitable. Over the last five years, the firm has averaged net margin of 6.04% and return on equity of 16.5%.

So I view it as a utility that’s just slightly more exciting than one of your run-of-the-mill utilities. And that’s because you’ve got the potential growth kicker from the partnership. In addition, I view the focus on transmission and distribution as fairly attractive.

But what’s perhaps most exciting about CNP at this very point in time is the valuation…

The P/E ratio is 15.38 right now after dropping more than 20% this year. That compares very favorably to the five-year average P/E ratio of 20.2 for this stock. And as mentioned earlier, the current yield is more than 100 basis points higher than its five-year average.

So we have a pretty big spread between the current valuation and recent historical valuation. But what is the stock worth?

I valued shares using a dividend discount model analysis with a 9% discount rate and a 4.5% long-term dividend growth rate. That dividend growth rate is on the low end of company guidance, and in line with recent dividend raises. Thus, I think it’s very reasonable. The DDM analysis gives me a fair value of $22.99.

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.

When putting it all together, I think we’ve got a utility that’s perhaps just slightly more exciting than a lot of others. But the current valuation really amplifies my enthusiasm. However, I’m not the only one around looking at CNP, its business model, and the valuation.

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 CNP as a 5-star stock, with a fair value estimate of $23.00.

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 CNP as a 2-star “sell”, with a fair value calculation of $17.40.

I came in within a penny of Morningstar, but S&P Capital IQ believes the stock is slightly overvalued. That’s why I like to average out these three numbers – it smooths the results out and allows us to work with one number. The average of the three valuations is $21.13. So it stands to reason that this stock is potentially 14% undervalued right now.

sc cnpBottom line: CenterPoint Energy, Inc. (CNP) is an interesting utility with a focus on transmission and distribution, along with the differentiation and potential growth its substantial ownership in midstream pipeline assets offers. But what is possibly most exciting right now about this stock is the sky-high yield that’s quite a bit higher than what it’s historically offered, along with being much higher than the broader market. In addition, the stock appears to come attached with 14% upside on top of that. I recently initiated a position here. I’d recommend taking a serious look at this stock.

— Jason Fieber, Dividend Mantra