A scandal can pop up at any time and burn a business.

I’m reminded of that over and over again.

The most recent reminder came about when video surfaced of a doctor from Louisville, KY being dragged down the aisle of United Continental Holdings Inc. (UAL) jetliner after said doctor refused to give up his paid-for seat when it came to light that United Continental overbooked their flight.

[ad#Google Adsense 336×280-IA]United Continental apparently had to make room for their own employees – and they tried to find volunteers to give up their seats.

When they couldn’t find volunteers, they started picking people at random.

The doctor in question was one of those people picked.

But he refused to deplane because he had clients to take care of in Louisville.

So United Continental called in law enforcement, who proceeded to drag the doctor out of the plane, injuring him in the process.

The video is obviously appalling on a number of levels.

But it was made even worse when the CEO of United Continental issued a pithy statement the morning after, seemingly blaming the customer for the issue.

There are a lot of lessons to be learned here about treating customers right and proper leadership coming from the top.

In the meanwhile, this incident is probably going to plague United Continental for quite a while, and it’s probably going to cost the company a lot of money (through lost business, a lawsuit, reputation damage, etc.).

This kind of problem can actually impair the value of a business, especially if the lost revenue is significant.

Now, you can argue as to whether or not United is worth less as a business after this incident.

But the point is that major scandals can and do pop up, and they can negatively impact a business for many years.

This is just one more reason why I focus on valuation when the time comes to invest in a business.

First, I don’t want to invest in a business that can’t or won’t pay growing dividends to shareholders.

After all, a dividend is a chunk of the profit a business generates.

As a shareholder, I believe I have a right to my fair share of a company’s profit. And as profit grows, so should my dividend.

That’s why I stick to high-quality dividend growth stocks like those you’ll find on David Fish’s Dividend Champions, Contenders, and Challengers list, which is an amazing compilation of more than 800 US-listed stocks with at least five consecutive years of dividend increases.

You can see that I walk the walk by checking out my real-life portfolio.

Sticking to high-quality dividend growth stocks has served me well, as my portfolio generates enough growing dividend income to cover the majority of my core personal expenses, rendering me essentially financially independent in my early 30s.

However, as I noted above, I always focus on valuation before I invest in a business.

This is for many reasons, including the potential for a large-scale negative event that can harm the intrinsic value of a business.

But that’s just one reason why valuation is important.

See, price is simply what you pay. A stock’s price only tells you how much a share will cost.

But value is what something is worth. A stock’s intrinsic value will tell you what you’re actually getting for your money.

Being able to buy a high-quality dividend growth stock for less than it’s worth – when a stock is priced below fair value – is beneficial for a number of reasons.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and less risk.

This is all relative to what would otherwise be offered if the same stock were fairly valued (priced equal to value) or overvalued (priced above fair value).

First, price and yield are inversely correlated.

All else equal, yield will rise as price falls.

This higher yield means more income in your pocket, assuming you’re investing a static amount of money.

You’ll be able to buy more shares at a lower price, and each share will have a higher yield.

This higher yield not only impacts your income, though.

It also impacts total return, as total return is simply dividends/distributions plus capital gain.

You can already see how the former is given a boost.

But the latter is also given a lift via the upside that exists between the lower price paid and the higher intrinsic value of a stock.

It’s been noted over and over again that while price and value can diverge significantly at times, price tends to roughly track value over the long term.

So if you pay $50 for a stock worth $75, you have $25 worth of upside that can, and likely will, materialize over the long haul.

In the meanwhile, you’re probably collecting more income all the way along.

This situation also has a way of reducing one’s risk, too.

Paying $50 for a stock worth $75 doesn’t only potentially give you a lot of upside; you also have a lot of downside protection.

Just in case a large-scale negative event happens, like a passenger being dragged off of a plane, you have plenty of cushion already built in via the margin of safety that exists when you pay less than what a stock is worth.

So if that same stock takes a hit to valuation and becomes worth, say, $70, you’re still looking at a lot of long-term upside (as well as that higher yield).

Fortunately, it’s not all that difficult to separate the undervalued dividend growth stocks from those that are fairly valued or, worse, overvalued.

A resource available right here on the site makes that a fairly simple prospect, as fellow contributor Dave Van Knapp put together a great (and free!) guide for valuing dividend growth stocks.

With all this in mind, I’m always on the lookout for a high-quality dividend growth stock that appears to be undervalued.

It’s not terribly easy to find these stocks seeing as how the broader market is still sitting near all-time highs, but a little diligence goes a long way.

Best of all, I’m going to share some of that diligence with you readers.

Wells Fargo & Co. (WFC) is one of the four largest banks in the US, with diversified financial offerings across retail, commercial, and corporate banking services.

Wells Fargo is an absolute behemoth in the banking industry.

They’re #1 in mortgage origination, auto lending, small business lending, commercial real estate origination, and mortgage servicing.

Essentially, they’re a leader in almost every banking category you can think of.

Moreover, they have over $1 trillion in core deposits.

These deposits are an incredibly low-cost and low-risk source of capital.

And since we see interest rates starting to rise, this capital becomes worth even more to the bank, as they’re able to make even more money on these deposits.

Indeed, rising rates could be a significant long-term tailwind for Wells Fargo (and most other banks, for that matter).

However, Wells Fargo had a scandal of their own not too long ago.

It turns out that aggressive sales tactics and an improper compensation structure led to the opening of fake accounts, costing Wells Fargo fines, lost customers, and reputation damage.

While the business has been impaired over the short term, the long-term value of this bank is still immense.

CaptureBut let’s first consider the dividend pedigree here.

The bank has increased its dividend for six consecutive years.

Not the longest dividend growth streak around, and that’s due to the fact that the bank was forced to cut its dividend during the financial crisis.

However, they have an otherwise excellent dividend track record dating back more than 30 years. Furthermore, the financial crisis was likely a once-in-a-generation event. On top of that, the dividend is now higher than it was pre-crisis.

That’s because of the aggressive dividend growth coming out of the depths of the Great Recession; the five-year dividend growth rate stands at 25.8%.

Now, that kind of dividend growth won’t continue, as much of that was an acceleration of dividend payouts coming off of the cut.

Nonetheless, the bank has plenty of capacity for dividend increases moving forward, as the payout ratio is sitting at a very comfortable 38.1%.

And that’s before even factoring in the tailwind from rising rates.

Plus, the stock offers a very appealing yield of 2.94% right now.

That’s well in excess of the broader market. It’s also more than 40 basis points higher than the stock’s own five-year average yield.

So the stock offers a yield near 3% on top of what’s likely to be very solid dividend growth over the next decade or so (assuming another major financial crisis doesn’t occur).

But in order to build an expectation for future dividend growth, we must first look at what kind of underlying growth the business is generating.

So we’ll look at what Wells Fargo has done over the last decade in terms of top-line and bottom-line growth. And we’ll then compare to that to a near-term forecast for profit growth.

Combined, this should help us determine what kind of growth Wells Fargo is generating.

And it’ll also help us value the business.

Wells Fargo has increased its revenue from $39.390 billion to $88.267 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 9.38%.

Huge top-line growth here, especially considering the fact that the financial crisis is in there. And this is a large bank we’re talking about.

However, that growth came about in part because Wells Fargo smartly acquired competitor Wachovia Corp. in 2009, which substantially increased Wells Fargo’s customer and deposit base.

I say smartly because there’s practically no better time to buy a bank than during a financial crisis, with fire-sale prices everywhere.

Wells Fargo did have to issue plenty of shares to fund the acquisition of Wachovia, though, so we’ll take a look at bottom-line growth in per-share numbers, which factors that dilution in.

The company’s earnings per share grew from $2.38 to $3.99 over this same time period, which is a CAGR of 5.91%.

So that’s pretty solid bottom-line growth for a large bank.

Looking forward, S&P Capital IQ believes Wells Fargo will compound its EPS at an annual rate of 5% over the next three years.

I find the deceleration an interesting call, considering that rates are rising. However, S&P Capital IQ (rightly) has concerns over the lingering effects from the fraudulent accounts scandal. Nonetheless, even 5% EPS growth could allow for strong dividend growth when taking the low payout ratio into consideration.

As one would expect of Wells Fargo, the bank’s fundamentals are impressive across the board.

The long-term debt/equity ratio is 1.28, which is in line with other major domestic banks.

Meanwhile, S&P rates their senior debt A, and Moody’s rates it A2.

Over the last five years, the bank has averaged net interest margin of 3.21%, return on assets of 1.36%, and return on equity of 12.98%.

Overall, Wells Fargo offers a lot to like.

That’s probably why Warren Buffett, via Berkshire Hathaway Inc. (BRK.B), has amassed such a large stake in the bank.

Of course, there’s always risk. And banks have certain financial risk that a lot of other companies in other industries don’t have.

But it does appear that Wells Fargo is finally moving on from its scandal. And the long-term tailwinds are clear.

Meanwhile, the stock is down almost 12% over the last month.

While it’s not nearly as cheap as it was when I covered the stock last summer, I still think there’s some value here…

The stock is trading hands for a P/E ratio of 12.97 right now. That’s higher than the stock’s five-year average; however, that period included a recovery off of post-crisis lows. Plus, one should consider that rates are finally rising. Furthermore, that P/E ratio is significantly below the broader market. Lastly, the stock’s current yield, as noted earlier, is higher than its own recent historical average.

What, then, might the stock be worth? What’s a reasonable estimate of its intrinsic value?

[ad#Google Adsense 336×280-IA]I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 7%.

That dividend growth rate is very reasonable, in my view, when looking at the underlying growth of the business and the very modest payout ratio.

5-6% EPS growth could still allow for 7%+ dividend growth with a slow, slight expansion of the payout ratio.

The DDM analysis gives me a fair value of $54.21.

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 analysis concludes the stock is slightly undervalued right now. But I’m mindful of the fact that my perspective is but one of many, which is why I like to compare and contrast my analysis with that of what professional analysts come up with. I think this comparison adds perspective and value for you readers.

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 WFC as a 4-star stock, with a fair value estimate of $66.00.

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 WFC as a 3-star “HOLD”, with a fair value calculation of $55.40.

So I came in the most conservative. Indeed, you could argue the dividend growth I modeled in was a little on the light side. But that’s why I like to add in these other analyses. Averaged out, we get a final valuation of $58.54, which would indicate the stock is potentially 13% undervalued.

WFC_chartBottom line: Wells Fargo & Co. (WFC) is one of the highest-quality financial institutions we have in this country. With rising rates providing a long-term tailwind, the odds seem strong that Wells Fargo will be much more profitable in a decade, which should provide plenty of room for more dividend increases. With 13% upside, plenty of room for huge dividend increases, and the chance to invest alongside Warren Buffett, this is a dividend growth stock that merits consideration.

— Jason Fieber

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