You should have a high degree of confidence that a company’s products and/or services will still be in demand (preferably more in demand) decades from now.

That’s essentially a primary responsibility of any long-term investor, in my view.

And questioning my confidence is something I do every time I look at a company for potential long-term investment.

My conviction in this responsibility has never been more tested than it has been lately, as I’ve practically been barraged with news stories about cryptocurrency.

When I look at a cryptocurrencies, I ask myself what degree of confidence I have that they’ll be in demand decades from now.

Well, I have almost no confidence whatsoever.

In fact, I’d go so far as to say I have no idea whether or not any of these cryptocurrencies will even exist at all 10 years from now.

While the underlying blockchain technology is interesting (as far as I can understand it), there are over 1,000 different cryptocurrencies in existence right now.

And it’s anyone’s guess which one – if any – goes on to become a widely-accepted form of payment over time. And even if one – if any – does go on to become a widely-accepted form of payment, it’s still anyone’s guess how much it will actually be worth.

You only need to get rich once. And getting rich isn’t all that difficult when you have a high degree of confidence that a company’s products and/or services will be in (greater) demand many years from now.

This is a tenet of my philosophy as a dividend growth investor.

Companies that provide products and/or services that experience plenty of demand over many, many years also tend to pay growing dividends, because these in-demand products and/or services are generating the rising profit required to perpetuate – and sometimes even necessitate – increasing dividend payments to shareholders.

I’ve almost exclusively stuck to investing in high-quality dividend growth stocks that can be found on David Fish’s Dividend Champions, Contenders, and Challengers list – a compilation of more than 800 US-listed stocks that have paid rising dividends each year for at least the last five consecutive years.

And the result of that is the six-figure dividend growth stock portfolio I now own and control.

That portfolio, by the way, produces the five-figure passive and growing dividend income I need to cover my real-life expenses, rendering me financially independent in my 30s.

Regardless of what happens with crytocurrency, I have a high degree of confidence that the companies I’m invested in will still be massively profiting from the products and/or services they sell, decades from now.

That said, investing in dividend growth stocks isn’t a strategy that should be blindly pursued.

One should always make sure they’re investing in high-quality companies that fit within their circle of competence, and they should make sure a full quantitative and qualitative analysis is performed.

And perhaps most importantly, one should make sure they’re paying attention to valuation so that they don’t pay far too much for their stocks.

This is a very important point because valuation can have an impact on one’s investment results, especially over a shorter period of time.

While price is what you’ll pay for a stock, value is what a stock is actually worth.

The latter gives context to the former. And having a good idea of the latter is arguably critical for a variety of reasons, as undervaluation (i.e., when the value of a stock is above its price) confers numerous benefits to the long-term investor.

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

That’s all relative to what the same stock might otherwise offer an investor if it were fairly valued or overvalued.

Price and yield are inversely correlated, meaning a lower price will, all else equal, result in a higher yield.

That higher yield automatically benefits one’s long-term total return potential due to the fact that income (via dividends or distributions) is one of two components of total return.

A higher yield equals more income on the same dollar invested in a stock.

But one’s long-term total return is given another possible boost via the “upside” that exists within that gap between price and value when undervaluation is believed to be present.

While price and value can wildly diverge in the short term due to the way emotions can run wild in the stock market, price and value tend to more closely correlate and converge over the long run.

If an investor is able to buy when the divergence is advantageous, the eventual convergence results in upside.

And that upside is on top of any organic upside that exists as a high-quality business naturally becomes worth more over time (as it sells more products and/or services, increasing its profit in the process).

These dynamics have a way of reducing one’s risk in a very obvious way.

After all, it’s clear that paying less for something is less risky than paying more, all else equal.

Furthermore, undervaluation can provide for a margin of safety, or a “buffer”.

This margin of safety means one is reducing their available downside, which decreases the chances that their investment becomes upside down (worth less than they paid) in case a fair value estimate is wrong or a company performs unexpectedly.

The good news is, it’s not some great mystery to estimate the intrinsic value of just about any dividend growth stock out there.

Fellow contributor Dave Van Knapp even put together a great article that specifically focuses on stock valuation, which is a “lesson” that’s part of an overarching series of lessons on the dividend growth investment strategy as a whole.

With these ideas in mind, I’m going to highlight a high-quality dividend growth stock that appears to be undervalued right now…

Ventas Inc. (VTR) is a real estate investment trust that invests in health care facilities that include seniors housing, skilled nursing facilities, hospitals, and medical office buildings.

The company’s investment portfolio encompasses interests in more than 1,200 properties that are spread out across the United States, Canada, and the United Kingdom.

Bringing things back to my earlier discussion on cryptocurrency, a new cryptocurrency can practically be created out of thin air, at any time.

But you can’t just create out of thin air a real estate portfolio like that of which Ventas controls. These are real properties with real value, and I have a high degree of confidence that they’ll be in demand for decades and decades.

A large, global trend serves as a massive tailwind for this company, ensuring my high degree of confidence.

That trend is the fact that the world is growing older, larger, and wealthier.

To wit, the 75+ population in the US is growing seven times faster than the general population (per the US Census Bureau).

As this continues to play out, demand for the very properties that Ventas invests in will almost certainly increase.

That’s because access to and demand for high-quality healthcare solutions (including facilities and housing that can accommodate older citizens who need assistance) will increase as the means and supply of clientele increase.

Said another way, if you have the ability to live a longer and/or higher-quality life, you’re going to do whatever you can to see that through. Then couple that with more people who are walking around, simultaneously living longer than ever before.

It’s easy to see how this trifecta of a trend bodes well for Ventas.

As such, it seems quite likely that the real estate investment trust’s ability to pay growing dividends for many years to come also bodes well.

As it sits, the real estate investment trust has been paying increasing dividends for eight consecutive years.

And I think that track record is just getting started.

What’s really wonderful about the stock’s dividend metrics is the fact that this is one of the best blends out there for both dividend income and dividend growth.

I mean, you really get to have your cake and eat it, too.

Consider the fact that the stock yields 5.78%.

The yield, by the way, is almost 100 basis points higher than the stock’s five-year average.

With that kind of yield, in this environment, I don’t see why an investor would be terribly unhappy with dividend growth that is simply keeping up with inflation (say, in the low single digits), keeping one’s purchasing power more or less intact.

But the five-year dividend growth rate is actually sitting at 7.6%, meaning you’re getting very strong dividend growth on top of a huge yield.

And with a payout ratio of just 75.2% (against TTM FFO/share), there’s still plenty of dividend growth to come, with an expectation that dividend growth should be roughly in kind with FFO/share growth moving forward.

There’s certainly, in my view, no danger of the sustainability of the dividend, at the very least.

You just don’t often see a yield near 6% along with 7% annual dividend growth, but that’s basically what you’re getting here with this stock.

It’s an uncommon combination of income and growth that’s pretty appealing.

Assuming a static valuation, the combination of yield and dividend growth should approximate total return, so we can all see a lot to like here.

But while we  know where dividend growth has been, we obviously do not and cannot know where it’s going to be five or ten years into the future.

That said, we can certainly put ourselves in a very good position to estimate forward-looking dividend growth with a reasonable degree of accuracy, which then greatly helps us value the business and its stock.

So what we’ll do next is start to build that expectation for future dividend growth.

And in order to do so, we’ll first look at what Ventas has done over the last decade in terms of top-line and bottom-line growth, which will show us exactly what kind of overall business growth the company is managing.

We’ll then compare that to a near-term forecast for profit (on a per-share basis) growth.

Blending the known past and an educated opinion of the future in this manner should give us a trajectory of where Ventas is going.

Ventas has increased its revenue from $772 million in fiscal year 2007 to $3.444 billion in FY 2016. That’s a compound annual growth rate of 18.08%.

This is an incredible growth rate on the face of it; however, REITs (including Ventas) routinely issue debt and equity to fund growth, as their very business structure requires them to pay out at least 90% of their taxable net income in the form of a dividend.

While this encourages fat, growing dividends, it means that a REIT must come up with capital (besides retained earnings) in order to grow.

Moreover, due to this unique structure, looking at net income and EPS is not an accurate way to gauge true profit.

The industry-accepted metric is instead funds from operations, which adds back in depreciation and amortization to earnings, while also subtracting any gains on sales.

Because real estate tends to actually appreciate over time (versus the depreciation that can happen on paper), FFO is a more true picture of a REITs earnings power.

And because of the way equity is often issued to fund growth, looking at FFO on a per-share basis is a far less muddy way of determining business growth, which will tell us a lot also about dividend growth potential.

Ventas grew its FFO/share from $3.07 to $4.13 over this same 10-year stretch, which is a CAGR of 3.35%.

That’s really a better look at the true growth the company has managed over the last decade.

We can see, though, that the dividend growth metrics above have obviously come at the expense of inflating the payout ratio.

While the payout ratio is not currently endangered in any way, one’s expectation for future dividend growth should be tempered relative to where things have been over the last 5-8 years.

Indeed, the most recent dividend increase was under 2%.

Looking out over the next three years, CFRA is calling for Ventas to compound its FFO/share at an annual rate of 3%.

That would be roughly in line with what’s transpired over the last decade.

There are concerns over supply and uncertainty in the broader healthcare industry weighing against tremendous long-term potential (due to the trifecta of tailwinds noted earlier).

Still, Ventas doesn’t need to go out and grow at 7% in order to make the investment very worthwhile over the long run, as the huge yield the stock pays out certainly goes a long way toward aggregate passive income and total return.

As a shareholder, I can tell you that I wouldn’t be at all unhappy if Ventas manages something between 3% and 4% growth over the next 5-10 years.

Looking at the balance sheet, there are no major issues here.

The company has $23.2 billion in assets against $12.4 billion in liabilities.

The balance sheet rates BBB+ from Standard & Poor’s; Baa1 from Moody’s.

In my view, there’s a lot to like here about Ventas.

The tailwinds propelling the company’s long-term potential are numerous and significant, and they’re unlikely to abate anytime soon.

People of a certain age that require healthcare (including appropriate housing) are going to do whatever they can to get it. With more people growing older and wealthier, the client pool for Ventas will almost surely expand.

While risks including regulation, possible healthcare reform, and changing supply-and-demand dynamics have to be considered, the business appears to be a low-risk avenue into both real estate and healthcare simultaneously – both industries that have been huge wealth creators for decades.

And while a new cryptocurrency could be created tomorrow, you can’t go out and create this kind of real estate portfolio overnight.

Moreover, while it’s nigh impossible to actually value a cryptocurrency, one could estimate with a reasonable degree of accuracy the intrinsic value of this company. To that point, the valuation looks quite attractive here…

The stock is trading hands for 13.46 times TTM FFO/share. Comparing that to a P/E ratio on a typical stock (roughly analogous), that’s quite low when considering the broader market sports a P/E ratio at almost twice that number.

Furthermore, the stock is valued at 5.6 times sales, compared to a five-year average P/S ratio of 6.7. The company’s cash flow is valued at a much lower level than it has been, on average, over the last three years.

And the yield, as noted earlier, is almost 100 basis points higher than its recent historical average.

The stock does look cheap, but how cheap might it be? What’s a reasonable estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

I factored in an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 3%.

The long-term dividend growth rate is quite a bit lower than the company’s five-year DGR, but I’m looking at the 10-year demonstrated FFO/share growth and the near-term forecast for FFO/share growth matching up pretty well, which would more or less drop down to dividend growth.

I may err on the side of caution here a bit (there’s more room for upside than downside here, in my view), but I think it’s always wise to be prudent when modeling things out over the long run.

The DDM analysis gives me a fair value of $65.10.

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.

Based on my valuation analysis, the stock is at least moderately undervalued here. Perhaps substantially so. But my perspective is but one of many. So let’s compare my valuation with that of what professional analysts have concluded.

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 VTR as a 4-star stock, with a fair value estimate of $65.00.

CFRA 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.

CFRA rates VTR as a 4-star “BUY”, with a fair value calculation of $57.91.

The latter firm has a 12-month target price of $66.00, which is right in line with the other valuations. But averaging these three numbers out gives us a final valuation on the stock of $62.67. That would indicate the stock is possibly 12% undervalued here.

Bottom line: Ventas Inc. (VTR) has one of the largest real estate portfolios in its industry. And this niche is a wonderful area to be in, as demographic trends all but guarantee greater demand for its properties going forward. A yield near 6%, inflation-beating dividend growth, and the potential that shares are 12% undervalued all add up to one of the more compelling opportunities in the REIT space right now for dividend growth investors.

— Jason Fieber

Note from DTA: How safe is VTR’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 70. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, VTR’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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