There are a number of reasons that people love sales.
I think it’s intuitive that people can understand the benefits of buying something for less than it’s worth.
First off, you’re saving money right off the top by not spending more than you otherwise would have.
If a good is worth $50 and was recently priced at $60, you’re effectively wasting at least $10.
But as soon as that good is marked down to $40, you’re seeing two benefits:
First, you’re saving money.[ad#Google Adsense 336×280-IA]Spending $40 instead of $60 is an extra $20 in your pocket.
And you had to do nothing for it.
Second, you’re acquiring something for a price less than it’s worth.
That second benefit might not be major windfall when it comes to consumer goods that quickly depreciate, but I can assure you it’s a massive benefit when it comes to buying stocks.
This is especially noticeable – and tangible – when looking at dividend growth stocks.
I write about and personally invest in high-quality dividend growth stocks (you can see my portfolio) because they reward shareholders with a growing source of passive income via regularly and reliably increasing dividends for years on end.
Dividends are the ultimate litmus test for real cash flow – the “proof in the pudding”, as you might say.
So when a company is able to increase cash payments to shareholders for decades on end, that tells you something is most certainly working for that business model.
Moreover, the growing dividends themselves can form the basis of a fantastic source of passive income.
I can tell you that I’m likely going to collect five figures in dividend income this year and every year thereafter, which puts me on pace for my long-term goal of financial independence by 40 years old.
You can find more than 700 examples of dividend growth stocks by checking out David Fish’s seminal Dividend Champions, Contenders, and Challengers list.
Now, buying a high-quality dividend growth stock at a price less than it’s worth – otherwise known as being undervalued – offers tangible benefits, as I mentioned earlier:
You’re locking in a higher yield, a higher potential long-term total return, and better dividend growth prospects – all with less risk.
Let me explain.
All else equal, a lower price on a stock equates to a higher yield. So that means paying less not only allows you to keep more money in your pocket today but also potentially locks in more income for the life of your investment. After all, would you rather have a 3.5% yield or a 3% yield on a stock? The former is simply more ongoing income on the same dollar-sized investment.
That higher yield of course leads to a higher possible long-term total return since yield is a major component to total return.
And the other component, capital gain, is given a big prospective shot in the arm by the very virtue of the possibility of the price on the stock increasing to reflect fair value on the market.
For instance, say a stock is estimated to be reasonably worth $100. You buy at $80, locking in that higher yield upfront. But you also have the likelihood that the stock closes the gap between $80 and $100 as the market participants realizes the mispricing that’s occurred.
Since we’re talking about dividend growth stocks, you also have to think about the additional dividend growth capacity when paying less for a stock.
7% dividend growth on a stock yielding 3.5% is naturally a larger absolute increase in your income over a 7% dividend increase on a stock yielding 3%. Whether we’re talking about the same dollar-sized investment or just buying more shares (spending the same amount of fixed money on stock but buying more shares when they’re cheaper), dividend growth is given a big boost when paying less.
And this all comes with less risk, naturally. Buying a stock at $80 is risking less capital than buying at $100. And it’s risking less downside when you put the possible upside, more income, and better dividend growth prospects on your side.
As such, I try to stretch my hard-earned dollars as far as possible and reap these aforementioned rewards by buying a high-quality dividend growth stock when it’s undervalued.
The good news is that this actually isn’t tough to accomplish in real life.
One just needs to be able to separate price from value.
Price is known. It’s the price quoted when you look at a stock.
However, value is a bit more difficult to ascertain. But we’re fortunate to be investing in the Information Age. High-value information that helps investors value stocks is more available than ever before.
A good example of this is fellow contributor Dave Van Knapp’s lesson on valuing dividend growth stocks, which is freely available (and extremely instructional) right here on the site.
Now that you see the incredible benefits, let’s take a closer look at a high-quality dividend growth stock that appears significantly undervalued!
Aflac Incorporated (AFL) is engaged in the business of offering supplemental health and life insurance in two major markets: the US and Japan.
This is really just one of the best insurers in the world, even though it likely flies under the radar for a lot of investors.
In fact, the first thing that might come to mind when you think about the company is the quirky ad campaigns that feature a duck that quacks “Aflac”.
But I can assure you the company is much more than funky advertising.
First, keep in mind that insurance is one of the oldest and best business models out there.
I say best because insurance companies are able to build up a float, which is the cash an insurance company keeps from the premiums they collect upfront until such time that claims are paid.
This float can become quite substantial, to the point where it generates so much investment income that it makes up the bulk of earnings.
For perspective, Aflac has built up an investment portfolio worth approximately $100 billion, with the vast majority of it invested in Japanese sovereign debt (Aflac does most of its business in Japan). And since this is a very low-cost source of capital, Aflac is able to invest it very conservatively and earn a nice return.
Combine that with a strong core business regarding premiums and you have a business model that can ooze cash.
And ooze they do. The company has increased its dividend for the past 33 consecutive years.
That time span stretches multiple recessions, wars, stock market crashes, and changes in government (both in the US and Japan). One great thing about insurance is that people are highly likely to retain their coverage, no matter what’s going on in the world.
The track record is mighty impressive. And it’s not like Aflac is handing out tiny dividend raises. Over the last decade, the dividend has increased at an annual rate of 13.6%, though recent increases have been much more modest in light of low interest rates.
On top of that, the stock yields a rather appealing 2.85% right now.
That’s quite a bit higher than th broader market.
In addition, it’s more than 30 basis points higher than the stock’s five-year average yield of 2.5%.
So that’s more ongoing income in the pocket of a buyer of Aflac now versus what’s typically been offered over the last five years.
With a payout ratio of 28.7%, there’s still plenty of room for future dividend increases.
Aflac’s payout ratio is very conservative, which is a reflection of the rest of the business. The good news about that is that you’re getting a pretty attractive yield right now with strong odds of pay raises above the rate of inflation for the foreseeable future.
With such strong dividend growth and a low payout ratio, one might surmise that the underlying business has been pretty strong in terms of growth.
We’ll take a look at that by focusing on the last decade of top-line and bottom-line growth, which tends to smooth out short-term issues and broader economic cycles.
Aflac’s revenue grew from $14.363 billion to $22.728 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 5.23%.
Meanwhile, the company increased its earnings per share from $2.92 to $6.50 over this period, which is a CAGR of 9.30%.
Fairly sizable share buybacks helped propel that excess profit growth. The outstanding share count is down by more than 10% over the last decade.
And the current buyback authorization amounts to another 10% or so of the outstanding float, so we should expect much of this to continue. I think that’s good news seeing as how the buybacks should be accretive when considering the shares appear undervalued here (as we’ll see below).
Moreover, the EPS growth in dollar terms has been constrained by a strong dollar as of late. In yen terms, the company’s growth has been even stronger. But the dollar has been strong and the yen weak lately.
Looking forward, S&P Capital IQ believes Aflac will be able to compound its EPS by an annual rate of 5% over the next three years, citing those currency effects. I believe Aflac’s long-term earnings power, assuming a normalization of currencies, is far greater.
The other major fundamentals are really just as solid as what we’ve already seen.
Like most other insurance companies, Aflac maintains a pretty conservative balance sheet.
The long-term debt/equity ratio is 0.29 and the interest coverage ratio is over 15.
Profitability is also extremely robust. It’s tough to do a direct comparison with a competitor because Aflac so thoroughly dominates its unique niche, but their margins and returns are excellent for the industry.
Over the last five years, the firm has averaged net margin of 12.98% and return on equity of 17.90%.
All in all, there’s really so much to like about the business model in general and Aflac specifically.
Aflac does most of its business in Japan, with more than FY 2014’s revenue generated in the country. They’ve done really well with distribution there, sporting agreements with approximately 90% of the banks in the country to sell its products. Japanese customers rely on banks to provide insurance products on top of traditional banking services. That’s in addition to the individual agencies that sell products. Aflac also sells a substantial portion of its policies through Japanese post offices.
Their distribution in the US is also impressive, with a sales force more than 70,000 strong. Aflac focuses on selling its products at consumer’s worksites, with products marketed directly to employees and sold as supplemental offerings on top of what employers already offer.
One last point to keep in mind is that since Aflac controls such a large investment portfolio that’s conservatively invested, incremental increases in interest rates could be a huge long-term tailwind.
With all this in mind, we might not expect shares to be discounted heavily. But that might be just what we’re looking at.
Shares are trading hands for a P/E ratio of 10.09. About half the broader market, there isn’t much Aflac has to do right to do well by shareholders. A more accepted metric for valuing insurance companies is the price-to-book ratio (reflecting the float). The stock sports a P/B ratio of 1.4 right now, which is a 17% discount to the five-year average of 1.7. And as discussed earlier, the current yield is notably higher than usual.
Seems like a cheap stock that’s also high quality, a rarity. But what’s a reasonable estimate of intrinsic 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 recent dividend growth has been lower than the long-term average, low interest rates and disadvantageous currency exchange rates are highly unlikely to last forever. The long-term picture remains bright, and the payout ratio is very low. The DDM analysis gives me a fair value of $70.52.
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.
I think the case for undervaluation is pretty clear and straightforward, but don’t just take my word for it…
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 AFL as a 4-star stock, with a fair value estimate of $69.00.
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 AFL as a 3-star “hold”, with a fair value calculation of $71.50.
Well, the trend is clear. I like to average out the three figures so as to work with one final consensus, and that final valuation figure is $70.34. With all three opinions being so close together, I have a lot of confidence in that number. And that number would indicate the stock is potentially 23% undervalued.
Bottom line: Aflac Incorporated (AFL) operates a great business model, with excellent underlying results in an industry niche. Furthermore, the company has clearly demonstrated its penchant for rewarding shareholders with growing dividends, and they have a lot of room in the tank for that to continue. With the possibility for 23% upside on top of a yield that offers a lot more current income than what’s typically been offered from the stock, I think this is a very appealing long-term investment at the current price.
— Jason Fieber[ad#DTA-10%]