You tend to get what you pay for in life.

When you see cheap merchandise, it’s oftentimes low quality.

Conversely, high-quality items usually fetch a premium.

But this isn’t always the case.

Especially when it comes to stocks.

And it’s the pursuit of high-quality stocks being sold on the market for less than what they’re likely worth that has made many, many high-profile investors like Warren Buffett extremely wealthy.

[ad#Google Adsense 336×280-IA]I share this pursuit, though I haven’t personally been anywhere near as successful as someone like Buffett.

However, I do, at 33 years old, control a six-figure portfolio that should spit out dividend income in the five figures this year, and I’m on pace to become financially independent well before 40 years old.

So I’m not doing too shabby.

What has helped me along the way is an ability to decipher the approximate value of stocks – seeing the difference between price and value – and then acting on that information.

The first part of that is, obviously, important.

Without knowing what something is worth, you can’t possibly hope to know whether or not the price is a good deal.

Value gives the necessary context to price.

And it’s so important to know value and attempt to buy when the asking price of a high-quality stock is below that value.

That action can increase your yield, improve your potential long-term total return, and reduce your risk at the outset.

Fortunately, there are a number of systems out there designed to help calculate a reasonable estimate of a company’s fair value.

One such system, proposed by fellow contributor Dave Van Knapp, is easily accessible right here on the site, and it’s particularly helpful when valuing dividend growth stocks.

Dividend growth stocks are all I write about and all I invest in.

If a stock doesn’t pay a dividend, I don’t even want to know about it.

After all, dividends are a substantial portion of the stock market’s total return over the last 100 years.

But dividend growth stocks don’t stop at just paying a dividend. No, sir.

They also increase their dividends year in and year out, leading to more income and purchasing power for shareholders.

And since increasing dividends are paid in cash money, they can only be paid if the underlying results from a company are also improving in time.

Basically, growing dividends tell you a lot about the overall health of a company. In addition, growing dividends also tell you a lot about a company’s willingness to share growing profit with its owners.

You’ll find more than 700 US-listed dividend growth stocks by checking out David Fish’s Dividend Champions, Contenders, and Challengers list.

A fantastic resource for any investor interested in growing dividend income, you’ll find hundreds of household names here.

But while focusing on high-quality businesses that reward shareholders with growing passive income and having the ability to reasonably estimate a stock’s fair value are, in my opinion, important aspects of achieving investing success over the long run, one also has to be able to act on this information.

And that’s what leads me to the subject of today’s article.

You’ll find below information on a high-quality dividend growth stock that appears to be undervalued right now.

So this is information you can act on and use to your advantage.

Of course, this isn’t a recommendation. It’s just information you can use.

But I think you’ll see a clear case for high quality and undervaluation…

Norfolk Southern Corp. (NSC) transports raw materials, intermediate products, and finished goods across the Eastern, Southeastern, and Midwest United States via approximately 21,000 miles of rail, and via interchange with rail carriers, to the rest of the US. They are a Class I railroad.

The railroad business is one of my favorites. It’s also a favorite for Buffett, seeing as how Berkshire Hathaway Inc. (BRK.B) owns the entirety of BNSF Railway.

It’s easy to see why.

The railroad business has incredible competitive advantages built right in.

It’s not like a major railroad network is going to be popping up anytime soon. The major legacy networks currently in place have their roots dating back more than a century, before the country was so widely populated. Attaining rights of way to install new track in 2016 would be nigh impossible for a new network, so spurs are all that are likely realistic moving forward.

That means competition is limited, with the few major railroads already in existence all able to rationally price their services.

In addition, there are significant cost advantages for rail via economies of scale, with the industry estimating that they’re four times as efficient as trucking per ton-mile of freight.

These advantages have helped Norfolk Southern build a fairly impressive track (pun not intended) record of dividend raises, with the company increasing its dividend over the past 14 consecutive years.

While the railroad industry might be a little cyclical due to its exposure to the broader economy, Norfolk Southern powered right through the Great Recession, increasing its dividend throughout.

And with a 10-year dividend growth rate of 17.3%, it’s not like these dividend raises have been pittance.

That rate of growth is well in excess of inflation over the last decade, meaning Norfolk Southern shareholders are seeing their collective purchasing power increase year after year.

The company’s payout ratio – a measure of the dividend against the earnings per share to support it – is sitting at 42.4% right now, meaning that less than half of underlying profit is being paid out to shareholders as a dividend.

nsc statsThat leaves a lot of room left for future dividend increases, though likely not at the rate we saw over the last decade.

But even if dividend growth slows some, investors that buy into this stock today are still locking in a yield of 3.27%.

That yield is pretty appealing no matter how you slice it. It’s well above the broader market, and certainly attractive in an environment where yield is hard to come by. Moreover, it’s more than 60 basis points higher than the stock’s own five-year average yield of 2.5%.

So the dividend metrics are pretty fantastic across the board. You’re getting a very attractive yield both in absolute and relative terms, and Norfolk Southern continues to boost its dividend like clockwork. With a modest payout ratio, I don’t see that changing any time soon.

But the dividend is only one part of the story, albeit a very important part.

Looking at the underlying financial performance and other fundamentals of the business will tell us a lot about where Norfolk Southern has been, where it might be going, and what its stock might be worth right now.

We’ll take a look at that underlying financial performance – via top-line and bottom-line growth – over the last decade first, which should help smooth out any short-term blips/headwinds.

Revenue is up from $8.527 billion to $11.624 billion from fiscal years 2005 to 2014, which is a compound annual growth rate of 3.5%.

Not outstanding top-line performance here, which might make the outstanding dividend growth perplexing.

However, the railroad’s steady buying back of its shares reduced its outstanding share count by almost 25% over the last ten years, and that led to much stronger bottom-line growth.

Earnings per share improved from $3.11 to $6.39 over this period, which is a CAGR of 8.33%.

Much more solid, although still a rate of growth well below that of the dividend. That’s why I believe that future dividend growth will slow, as I mentioned above. The payout ratio, while still moderate, has expanded some over the last ten years.

Looking forward, S&P Capital IQ believes that Norfolk Southern will compound its EPS at an annual rate of 10% over the next three years. That’s not terribly far off from what we see above, and that period coincides with a rather difficult period for economic expansion. Norfolk’s continued focus on buybacks and efficiency bode well for the firm and its shareholders.

One aspect of this business model that comes with the territory is the usage of debt. This is something unavoidable when investing in railroads, as we’re talking about a capital-intensive business with a heavy focus on infrastructure.

Nonetheless, Norfolk Southern’s leverage ratios are respectable, with no cause for concern.

The long-term debt/equity ratio is 0.72 and the interest coverage ratio sits over 6.

All in all, they maintain a competitive and rational balance sheet.

Profitability metrics are also really impressive, with Norfolk seeing slight improvements across the board over the last decade.

We can see over the last five years that the firm has averaged net margin of 16.58% and return on equity of 17.09%.

These are also very competitive numbers, relative to the nearest peers. I’m not sure how anyone could be less than happy with net margins in the upper teens.

Overall, this is just a great business model. And Norfolk Southern appears to be operating at a high level within that business model, with no major stumbles anywhere.

I find it highly likely that shareholders will continue to see higher and higher dividends over the foreseeable future, although dividend growth will likely slow from prior levels.

We have high-quality merchandise here. But is the price reflecting that?

The stock’s P/E ratio is sitting at 12.97. That’s well below the broader market. It’s also notably below the stock’s own five-year average P/E ratio. Furthermore, just about every other basic metric you can look at is below recent historical norms, with even those recent historical norms also being quite appealing.

Seems to be a stock that went from pretty attractively valued to even cheaper. What’s a reasonable estimate for fair value?

I valued shares using a dividend discount model analysis with a 10% discount rate and a 7.5% long-term dividend growth rate. Although that growth rate is on the upper end of what I usually allow for, it’s also less than half Norfolk Southern’s ten-year dividend growth rate. Based on what I see above, I think this is a reasonable long-term expectation. The DDM analysis gives me a fair value of $101.48.

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.

In my view, this stock trades for a price well below what it’s really worth. And it’s in these kinds of disconnects that many of the all-time great investors have made plenty of money. But don’t take just my word for it. Let’s see what some professional analysts think about this stock’s 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 NSC as a 4-star stock, with a fair value estimate of $102.00.

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 NSC as a 3-star “hold”, with a fair value calculation of $76.70.

Interestingly, S&P Capital IQ rated the stock’s fair value well over $100 just this past spring, so the change is, from my perspective, somewhat reflexive. Nonetheless, averaging out these three figures (so as to smooth the fluctuations) gives us $93.39. That would indicate the stock is potentially 29% undervalued right now.

nscBottom line: Norfolk Southern Corp. (NSC) is a high-quality company operating in an industry that practically ensures an intact competitive position and increasing profit over time. The yield is much higher than its recent historical average and the stock appears poised for 29% upside on top of that. If you’re looking for exposure to this industry, this stock should absolutely be on your radar.

— Jason Fieber, Dividend Mantra