I’m a huge proponent of the dividend growth strategy.
This strategy dictates that one should invest only in companies that share their growing profit with shareholders in the form of growing dividends.
After all, it makes a lot of sense when you sit down and think about it.
Would you want to invest in a company that isn’t growing its profit fairly regularly over the long run?[ad#Google Adsense 336×280-IA]I don’t think you would. I certainly wouldn’t.
And as a part owner of a company (that’s really what a shareholder is), would you not expect your fair share of the growing profit a company generates?
I can’t speak for you. But I know that I want my rightful share.
And it’s this rightful share that has done well by me.
So well that the dividend income my personal portfolio generates is just about enough for me to live of off – and I’m only in my early 30s.
I simply save as much as I can and then invest that excess capital into high-quality dividend growth stocks, collecting and reinvesting that growing dividend income all along the way.
Incredibly simple. Incredibly effective.
The stocks I write about and personally invest in can be largely found on David Fish’s illustrious Dividend Champions, Contenders, and Challengers list, which is a compilation of the more than 750 US-listed stocks with at least five consecutive years of dividend increases.
If a US-listed stock has a demonstrated track record of dividend increases (at least five years), you’ll find it there.
Whenever I’m looking for an investment idea (that isn’t already in my portfolio), this is my first stop.
But while high-quality dividend growth stocks have treated me well, and while I’m a huge fan of this strategy, one shouldn’t go out and buy any random stock off of Mr. Fish’s list at just any random time.
One should obviously first make sure they know what they’re investing in. And one should always perform the necessary due diligence to make sure the fundamentals and qualitative aspects pass muster.
However, if a dividend growth stock does pass that muster and appears to be high quality, it’s just as important, if not more so, to make sure the valuation is appropriate.
Said another way, you want to pay a price that is in line with or less than what a stock is worth.
Specifically, you should aim to buy high-quality dividend growth stocks when they’re undervalued.
The price of a stock simply represents what it costs; the value of a stock is what it’s actually worth.
And the more favorable the gap between the two (the more undervalued a stock is), the more beneficial it is to a long-term investor.
These benefits of undervaluation are clear and compelling: higher yield, the potential for greater long-term total return, and less risk.
Since price and yield are inversely correlated, the yield will almost always be higher when the price of a stock is lower. All else equal, yield always rises when price falls.
This has a positive effect on the expected long-term total return, with yield being a major component of total return.
Meanwhile, your potential long-term capital gain is also given a boost because of that favorable gap just mentioned earlier – the gap that exists between the (lower) price paid and the (higher) value of a stock is additional long-term upside on top of any upside that already existed as part of day-to-day operations slowly improving the value of a company.
Of course, this all works to also reduce risk.
In case a company turns out to not be worth as much as you thought, that gap between the price you paid and the (now lower) value of the stock simply closes somewhat rather than the investment turning upside down on you right away.
And the less a stock costs on a per-share basis, the less capital that’s required upfront to acquire a specific number of shares.
With all of these benefits in mind, it should now be obvious that high-quality dividend growth stocks that are undervalued are highly desirable.
Better yet, it’s not all that difficult to value dividend growth stocks on an individual basis so as to find those stocks on Mr. Fish’s list that are attractively valued.
One just needs a system designed to determine value, independent of price.
A great system that can do just that was put together by fellow contributor and dividend growth investor Dave Van Knapp.
It’s part of his overarching series of lessons on dividend growth investing – and it’s perhaps the most important lesson of all.
With all of that in mind, I’m going to showcase a high-quality dividend growth stock that right now appears to be significantly undervalued.
Tiffany & Co. (TIF), through its subsidiaries, primarily designs, manufactures, and sells engagement jewelry, statement jewelry, and fashion and designer jewelry across more than 300 stores located in 25 countries. In addition, they offer a number of gifts and accessories.
Founded in 1837, this company has demonstrated a very rare type of enduring staying power.
It’s now one of the world’s most recognized and respected brands for luxury jewelry.
Because of that, Tiffany should be able to maintain its premium pricing model over the long run, lending itself to healthy margins and profit growth.
Moreover, jewelry is something that civilizations have been coveting since the dawn of time – I find it likely that this continues indefinitely, meaning, even though it’s almost 180 years old, Tiffany is probably still in its early innings.
With the Americas representing approximately half of the company’s net sales and only a little over 300 stores worldwide, there’s still a lot of potential for international growth here.
Considering all of that, there’s a lot to like here just in terms of the base business.
But it would mostly not be for me if the company didn’t share its growing profit with shareholders.
Fortunately, this is a great example of just the opposite.
Tiffany has increased its dividend for the past 14 consecutive years.
They actually have a pretty rich dividend history that goes back decades, but there have been stretches where the dividend was static.
Nonetheless, the dividend has grown at a compound annual rate of 23% over the last decade.
That, in my view, makes up for a lot of lost ground.
And with a payout ratio of just 51.7%, there’s still a lot of room for future dividend raises.
In fact, I consider a payout ratio of 50% as the “optimal” split between retaining profit for internal growth and sharing profit with the owners in the form of a dividend. Tiffany is basically right there.
These stats are bolstered by the fact that the stock yields 2.87% right now.
So you’re getting a yield that’s well in excess of the broader market, a payout ratio that’s almost perfect, and a dividend that’s growing pretty tremendously.
Consider, too, that the stock’s current yield is more than 100 basis points higher than its five-year average of 1.8%.
Whereas shareholders have been willing to accept a yield well below 2%, on average, over the last five years, investors today are looking at a stock that offers much better income prospects.
And that should have a strong beneficial effect on not only your income but also your long-term total return going forward, as noted earlier.
All in all, the dividend metrics are pretty fantastic.
Let’s next take a look at what kind of growth the company has posted over the last decade.
We’ll look at both top-line and bottom-line growth, before comparing that to a near-term forecast.
This will help us determine not only what kind of dividend growth to expect in the future but also what the stock might be worth.
Tiffany has increased its revenue from $2.648 billion to $4.104 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 4.99%.
Meanwhile, the company’s earnings per share grew from $1.80 to $3.59 over this 10-year period, which is a CAGR of 7.97%.
Improving profitability across the board, along with a slight reduction in the outstanding share count, helped propel that excess bottom-line growth.
Looking out over the next three years, S&P Capital IQ believes Tiffany will produce 10% compound annual growth in their EPS. Further margin improvement, the opening of stores, and e-commerce growth is expected to offset the strong dollar and weakness in recent same-store sales trends.
That could prove to be a bit optimistic with slowing global growth and uncertainty in Europe, but I think the 8% the company has delivered over the last decade is a very reasonable baseline to work with when looking out over the long haul.
The rest of the company’s fundamentals are very solid, including the balance sheet.
A long-term debt/equity ratio of 0.27 and an interest coverage ratio over 15 both indicate a very healthy financial situation with no concerns whatsoever.
That aforementioned improving profitability is further evidence of the company’s brand power and quality.
Over the last five years, Tiffany has averaged net margin of 10.04% and return on equity of 15.33%.
These numbers are both a marked improvement on the prior five-year period and what major competitors are putting up.
We’ve got a very simple business model predicated on humanity’s affinity for jewelry. They offer a premium product and experience, and I believe this will continue to endure.
In fact, I recently initiated a position. There’s just not really anything to strongly dislike, other than some recent stumbles, which, I believe, are not only temporary but also more than factored in – the stock is down more than 32% over the last year. Is Tiffany now only 2/3 the company it was a year ago? I think not.
I would argue this is a high-quality company. The fundamentals across board are rather fantastic, which would imply that the stock is worth a premium.
Yet the stock actually appears to be offered at a discount…
The P/E ratio for this stock is sitting at 18.03 right now, which is much lower than the broader market. That’s also almost 40% below the stock’s own five-year average of 29.3. Furthermore, every other basic metric I look at (P/S, P/B, P/CF) is substantially lower than its respective five-year average. And then, as noted earlier, the yield is far higher than what it’s averaged over the last five years.
So it’s cheap across the board. But how cheap? What’s an estimate of this stock’s intrinsic value?
I valued shares using a dividend discount model analysis. I assumed a 10% discount rate and a long-term dividend growth rate of 7.5%. This growth rate builds in a small margin of safety when comparing the company’s demonstrated long-term earnings growth, as well as the forecast for bottom-line growth moving forward. In addition, the payout ratio offers some flexibility. The DDM analysis gives me a fair value of $77.40.
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 view is that this stock is meaningfully undervalued right now, even when the valuation analysis is arguably conservative. Is that view shared by professionals that have taken the time to analyze and value Tiffany’s stock?
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 TIF as a 4-star stock, with a fair value estimate of $85.00.
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 TIF as a 3-star “hold”, with a fair value calculation of $70.60.
Looks like I came in right in the middle. But I like to average these three different perspectives out so as to concentrate this information and, hopefully, increase the accuracy. That averaged valuation is $77.66, which is just pennies away from my number. That would indicate this stock is potentially 24% undervalued.
Bottom line: Tiffany & Co. (TIF) has been around for almost two centuries. I see no reason why it won’t be around for another 200 years. The fundamentals are high quality across the board, the dividend metrics are very appealing, and the future growth potential looks very strong. In addition, the stock offers the possibility of 24% upside. If you’re looking for a long-term dividend growth investment right now, I don’t think you can do much better than this.
— Jason Fieber[ad#IPM-article]