There’s this dynamic that most of society believes is absolutely necessary, as if there’s no other way.
That dynamic is one where a person is paid only if they work for the money.
This means there’s a widespread belief that there’s always and only a direct correlation between effort/time expended and money received; if you don’t work, you don’t get paid.[ad#Google Adsense 336×280-IA]I once believed wholeheartedly in this, that the only way I could ever get a check was to work for it.
But then I realized in my late 20s that there’s a fantastic way to circumvent this, and one can be paid for doing absolutely nothing.
Dividend growth investing is that circumvention.
Indeed, the real-life, real-money portfolio that I’ve been busy building out since 2010 is on pace to send me five-figure dividend income over the next 12 months.
Guess how hard I have to work for that money?
I’ll save the suspense: I don’t have to lift a finger.
What better relationship between time and money could possibly exist than one where the former doesn’t have to be exchanged for the latter?
Dividend growth investing allows one to buy shares in wonderful businesses that reward their shareholders with a chunk of the growing profit these businesses generate; as profit grows, so do the dividend payments.
Those growing dividend payments keep management honest, and they serve as “proof in the pudding”.
Moreover, the growing dividend income one earns can be an excellent source of completely passive income, thus providing the aforementioned circumvention.
And one is never short on opportunities.
You can find more than 800 US-listed dividend growth stocks by checking out David Fish’s Dividend Champions, Contenders, and Challengers list, which is a fantastic compilation of stocks that have paid increasing dividends to shareholders for at least five consecutive years.
But that doesn’t mean an investor should be plucking random stocks off of that list and buying them at prevailing prices.
That would be like going to a store, buying random merchandise, and paying whatever price was listed on price tags.
Said another way, one should look to buy the right stocks at the right prices.
While there’s no objective way to describe “right” stocks, long-term investors looking to intelligently allocate capital should be aiming to invest in quality businesses that feature great fundamentals. For example, one should look for growing revenue and profit, a solid balance sheet, great cash flow, and high relative margins.
Investing in a business that’s within one’s own circle of competence is also important.
And any great company should have competitive advantages.
Paying the “right” price is also not something that can be completely quantified, although it’s also not all that difficult to know when you’re in the right area.
See, price is what you pay. But value is what you’re getting in return for your money.
Value is worth. Value gives context to price. Without knowing value, it’s nigh impossible to know whether or not price is appropriate.
Within the framework of dividend growth investing, it’s practically never more important to have a good idea of value before one buys the “merchandise”.
Fortunately, there are many tools that are freely and easily accessible, designed to help investors estimate the value of just about any dividend growth stock.
One such resource is fellow contributor Dave Van Knapp’s lesson on valuation, which itself is part of an overarching series of lessons that teach investors how dividend growth investing works and why it’s such an effective investment strategy.
Once you have value in mind, you can determine whether or not price is appropriate.
Well, the “right” price is one that’s as far below fair value as possible.
Said another way, one should always aim to buy high-quality dividend growth stocks when they’re undervalued.
Undervaluation is appealing to long-term dividend growth investors for a variety of reasons.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return, and less risk.
This is all relative to what the same stock would offer if it were fairly valued (priced at fair value) or overvalued (priced above fair value).
It’s easy to see how these benefits materialize when undervaluation is apparently present.
For instance, price and yield are inversely correlated; a lower price will result in a higher yield, all else equal.
This higher yield also positively impacts total return, as total return is simply made up of capital gain and dividends/distributions. Well, higher dividends obviously help propel total return higher.
In addition, capital gain is given another boost via the “upside” that exists between the lower price paid and the higher intrinsic value of a stock.
If a stock worth $50 is bought for $40, there’s $10 worth of possible upside that could be captured if/when the market realizes the fair value of the stock and prices it appropriately.
While the market isn’t necessarily very good at doing this over short periods of time (leading to the very opportunities we’re discussing here), price and value tend to often converge over longer periods of time.
And that upside is on top of whatever upside that naturally exists as the business becomes worth more over time (as it sells more product and/or services, increasing profit and becoming a bigger company).
This all works to reduce one’s risk, too.
After all, paying less is naturally not as risky as paying more. And you’re likely risking less capital (assuming a static number of shares purchased) on top of that. Or you’re getting more shares for the same amount of money.
With all this in mind, undervalued high-quality dividend growth stocks can make excellent long-term investments.
But I won’t leave you readers there.
I’m going to expose what appears to be an undervalued dividend growth stock, which could be a great long-term investment opportunity here…
Cisco Systems, Inc. (CSCO) is the world’s leading designer, manufacturer, and supplier of data networking equipment and software.
Technology isn’t the first sector I think of when I think of everlasting dividend growth; the world of tech changes fast, which can take a lengthy dividend growth record with it (if a company doesn’t respond/change fast enough).
However, the idea of investing in tech today is a lot different than it was even just 15 years ago.
Investing in tech got a really bad name back when the dot-com bubble burst, taking plenty of investors’ money with it.
But that’s because the dot-com bubble featured a lot of companies that weren’t large and/or profitable, or had no leading global positions in products and/or services that are practically necessary and/or ubiquitous to everyday society. You certainly didn’t see lengthy track records of growing dividends from many of these upstarts.
That’s a very different scenario than the one we find ourselves in today.
There are actually a large number of global tech companies that are extremely profitable and, partly as a result, pay out large and growing dividends to shareholders.
My general thesis when it comes to investing in tech companies is to diversify across a number of the highest-quality and most profitable dividend growth stocks in the space, limiting myself to those companies that have demonstrated an ability to change/adapt over time (with the dot-com bubble itself being a nice test of that).
Well, Cisco is one such company.
This is a $156 billion company (by market cap) that has a dominant position in routers and switches, and they’re a well-positioned company to take advantage of the increasing move toward the Internet of Things as people, government, and businesses continue to rely more on the digital space for everyday activities.
Meanwhile, investors are collecting a very appealing dividend that’s growing at a rapid pace.
The company has paid an increasing dividend for seven consecutive years.
While not a particularly impressive track record in absolute terms, it’s actually fairly competitive in the tech space.
What they perhaps lack in terms of length, they make up for in growth: the five-year dividend growth rate is a monstrous 40.6%, which is one of the highest numbers you’ll find.
However, much of that growth was fueled by getting the dividend up to speed, as the company was going from no dividend to paying out a large chunk of its profit via that dividend.
As such, recent dividend growth has slowed, with the most recent increase being about 11.5%. That’s probably a more realistic expectation for the near term.
The payout ratio remains reasonable, at 58.6%.
But what might just be the most appealing aspect of the dividend is the yield.
The stock offers a very attractive yield of 3.68% right now.
That’s much higher than what the broader market offers. In addition, it’s almost 90 basis points higher than the stock’s own five-year average yield.
So that relationship between valuation and yield, mentioned above, is revealing itself here.
There’s definitely a lot to like about the dividend. The yield is quite high, the dividend is growing at a rapid rate, and the payout ratio leaves room for continued dividend growth.
But in order to determine what to expect moving forward, we must first look at what kind of underlying growth the business is generating. This will not only help us estimate an expectation in regard to dividend growth, but it will also help us value the business.
We’ll first look at what Cisco has done in terms of top-line and bottom-line growth over the last decade, and then we’ll compare that to a near-term forecast for profit growth. Combined, this should give us an idea as to the overall growth Cisco is producing, which should more or less translate to the dividend.
From fiscal years 2007 to 2016, the company increased revenue from $34.922 billion to $49.247 billion. That’s a compound annual growth rate of 3.89%.
Meanwhile, Cisco increased its earnings per share from $1.17 to $2.11 over this period, which is a CAGR of 6.77%.
These are fairly solid numbers, considering that Cisco is a mature company in a competitive industry.
The excess bottom-line growth can be explained via share repurchases: Cisco reduced its outstanding share count by approximately 19% over the last decade.
Looking out over the near term, S&P Capital IQ is forecasting 3% compound annual growth for Cisco’s EPS over the next three years.
That would be a large drop from what Cisco has done over the last decade. S&P Capital IQ sees soft sales offset somewhat by ongoing share repurchases.
For perspective, Cisco’s most recent quarter showed 5% year-over-year EPS growth.
Even with a slowdown in EPS growth, however, the moderate payout ratio should allow for at least mid-single-digit dividend growth for the foreseeable future.
And that’s before factoring in the company’s balance sheet, which provides a substantial amount of flexibility both in terms of increasing the dividend and funding acquisitions (which could fuel higher growth).
The long-term debt/equity ratio is 0.39, while the interest coverage ratio is just over 20.
While these are very solid numbers already, the key to Cisco’s balance sheet is knowing that they have over $65 billion in cash.
The long-term debt is sitting at over $24 billion, so the net cash position is still considerable, at over $40 billion.
So even absent much bottom-line growth over the near term, the dividend could continue growing at a pretty attractive rate for years to come.[ad#Google Adsense 336×280-IA]That said, much of this cash is overseas, so the company’s flexibility is slightly limited.
Cisco’s balance sheet is incredibly strong, and the high-quality fundamentals continue when looking at the company’s profitability.
Over the last five years, Cisco has averaged net margin of 18.50% and return on equity of 17.22%.
The margins in particular are robust.
Overall, I don’t see much to dislike about this stock from the perspective of a dividend growth investor.
There are always the risks of competition and obsolescence when investing in just about any company, but tech firms face these risks more specifically and directly.
However, Cisco is dominant in its key markets, has shown an ability to adapt and change as necessary, is sitting on a ton of cash, and pays out a huge dividend.
Yet the stock looks like a fairly good deal here…
The stock is trading hands for a P/E ratio of 15.98 right now. While above the stock’s own five-year average, that’s well below both the broader market and the industry average. Plus, that’s not even backing out the cash. Moreover, the yield, as noted above, is substantially higher than its five-year average.
So how good of a deal might this be? What’s a reasonable estimate of the stock’s intrinsic value?
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 growth rate is roughly on par with the company’s long-term EPS growth rate, and I think it’s reasonable when also looking at the recent dividend growth, payout ratio, and cash position.
The DDM analysis gives me a fair value of $41.37.
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.
Unless Cisco’s long-term growth becomes somehow severely hampered, which would translate into much lower dividend growth than what I’m forecasting, the stock looks undervalued. And keep in mind that lower EPS growth could be balanced/buttressed by the cash.
But in order to keep me honest, add perspective, and balance my view, I like to compare my analysis/valuation with that of what select professional analysts have come up with.
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 CSCO as a 3-star stock, with a fair value estimate of $33.00.
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 CSCO as a 3-star “HOLD”, with a fair value calculation of $32.90.
Averaging out the three numbers gives us a final valuation of $35.76, which would mean this stock is potentially 13% undervalued.
Bottom line: Cisco Systems, Inc. (CSCO) is a dominant company in a number of key products, which positions them incredibly well for taking advantage of increased traffic in the digital space. With a huge dividend, a massive cash position, plenty of room for future dividend growth, and the possibility of 13% upside, this long-term opportunity should be strongly considered in this market.
— Jason Fieber[ad#IPM-article]