We live in a world of abundance.
If you’re reading this article, you’re experiencing plenty of abundance.
Look around you.
What do you see?
I can tell you what you see.
You see huge houses, luxury cars, fancy electronic gadgets, plenty of food, and cities that are brighter at night than they are during the day.
But you know what isn’t in abundance for many people living in developed countries?
That’s because it takes a lot of work and a lot of money to keep up the abundance I just noted.
This leads to a scarcity when it comes to one’s time, flexibility, and freedom.
While it might seem nice to own a bunch of stuff, stuff can end up owning you.
Furthermore, it’s actually less tangible concepts like time, control, options, and autonomy that tend to provide the bulk of long-term life fulfillment for a person.
This is why financial independence is the solution.
If you have control over your life, all while simultaneously taking advantage of modern-day abundance, you can more or less have your cake and eat it, too.
My personal realization of this started to come about back in late 2009, upon which time I embarked on a multi-year journey to become financially independent.
I saved and invested as much money as I possibly could – all on a very middle-class salary.
This eventually led to the real-life and real-money six-figure stock portfolio I own and control today.
That portfolio generates the five-figure and growing passive dividend income I need to sustain myself in life, rendering me financially independent in my early 30s.
I no longer need to work at a job in order to pay my bills; in fact, I haven’t worked at a day job in almost five years now.
But investing appropriately was a key aspect of my entire plan.
And the investing strategy I chose to buy my financial freedom was (and still is) dividend growth investing.
This strategy essentially involves buying up shares in wonderful businesses that share their massive profits with shareholders, in the form of dividends.
And as these companies’ profits grow (profit growth usually happens when you’re dealing with wonderful businesses), so do those dividend payments.
It’s almost a foolproof strategy.
As you might imagine, many high-quality dividend growth stocks are also blue-chip stocks.
You can see what I mean by checking out David Fish’s Dividend Champions, Contenders, and Challengers list – it’s the most complete list of dividend growth stocks I know of, which includes invaluable information on more than 800 US-listed stocks that have raised dividends each year for at least the last five consecutive years.
Building a portfolio full of high-quality dividend growth stocks can result in not just the passive dividend income you need to become financially independent, but the very nature of dividend growth stocks means that passive dividend income should be regularly and reliably increasing and thus improving your purchasing power over time.
But this isn’t an investment strategy that one can approach blindly.
One needs to make sure they’re investing in the right companies at the right prices.
The right company is one that’s within one’s circle of competence. And it should exhibit the quantitative and qualitative qualities that would indicate a great business.
The right price is, of course, one that’s as far below estimated intrinsic value as possible.
Price is what you’ll pay for something, but value is what something is actually worth.
If you’re able to invest in a high-quality dividend growth stock when price is well below intrinsic value (i.e., undervaluation), you’ll likely be taking advantage of multiple powerful, long-term benefits.
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 if it were fairly valued or overvalued.
The higher yield comes about because price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.
That higher yield (which results in more investment income) gives long-term total return potential a boost right off the bat, as investment income (via dividends or distributions) is one of two components of total return.
And the other component, capital gain, is also given a boost via the “upside” that exists between the lower price paid and the higher intrinsic value.
If/when this favorable gap is corrected by the market, it will result in capital gain for the investor, which is on top of whatever natural upside is/was possible as a high-quality business becomes worth more through the process of increasing its profit.
Finally, it should go without saying that paying less for the same asset reduces your risk.
It’s just like any other asset.
If you deem a stock to be worth $50, it’s of course less risky to pay $30 than it is to pay $70.
When a stock appears to be undervalued, this introduces a margin of safety for the investor.
And this is important because intrinsic value is always an estimate. As such, you always want to err on the side of caution when it comes time to buy a stock and pay your price.
In addition, a business could always perform less stellar than expected (or do something really wrong), reducing current fair value.
Estimating fair value is of the utmost importance for an investor, and it should occur before buying any stock.
Fortunately, the process of valuation isn’t particularly difficult.
Fellow contributor, writer, and dividend growth investor Dave Van Knapp wrote a great series of “lessons” on dividend growth investing, and one of these lessons is specifically on valuation.
This valuation lesson can and should make the process of valuing just about any dividend growth stock out there pretty straightforward and simple.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to currently be undervalued…
Apple Inc. (AAPL)
Apple Inc. (AAPL) is a designer and manufacturer of consumer electronic devices, including smartphones, computers, tablets, smartwatches, and TV boxes. The company also provides a number of complementary and supportive services across apps, music, file storage, and payment.
Net sales by product breaks down as such: iPhone, 62% of FY 2017 sales; Services, 13%; Mac, 11%; iPad, 8%; Other Products, 6%.
Net sales by operating segment breaks down as such: Americas, 42% of FY 2017 sales; Europe, 24%; China, 20%; Japan, 8%; Rest of Asia Pacific, 7%.
Apple really needs no introduction.
It’s one of the world’s largest and most successful companies, with a market cap of over $800 billion.
I mentioned earlier taking a look around you.
Well, take a quick tour of your local shopping mall, downtown, or neighborhood and see how many people are using Apple products. You won’t have to search hard or look far to find plenty of people using iPhones, IPads, and Macs.
Being this large has benefits and drawbacks.
A benefit is that the company is producing gobs and gobs of cash flow, which provides them with plenty of ammunition with which to return cash to shareholders via a big and growing dividend.
For perspective on this, Apple spends approximately $13 billion per year on its dividend payments, which makes it one of the biggest dividend payers in the world (if not the biggest payer).
And after the passage of the Tax Cuts and Jobs Act of of 2017, Apple plans to repatriate most of the ~$250 billion in cash it holds overseas.
It gets better, folks.
The company has announced (during its Q1 2018 earnings call) that it plans to run a net cash-neutral business going forward, which very likely means Apple will be allocating the majority of that cash toward buybacks and dividends over an unspecified period of time.
With net cash (after factoring out debt) currently coming in at over $160 billion, one can easily surmise that the company’s dividend will be growing rather significantly over the near term (and even over the long term).
That’s music to this dividend growth investor’s ear. And it puts the stock’s valuation in a new light.
First, let’s look at the company’s dividend metrics as they stand today.
The company has increased its dividend for six consecutive years.
This is certainly not the longest streak around, and it’s not even particularly lengthy for a large-cap tech company.
But Apple was historically not a dividend payer at all. However, this changed not long after Tim Cook took over as CEO of the company due to the health issues that plagued (and later took the life of) co-founder and previous CEO Steve Jobs.
Since initiating the payment of a dividend, they’ve been diligently increasing it like clockwork. I expect this to continue for the foreseeable future, especially in light of the new and more aggressive capital allocation policy.
The five-year dividend growth rate stands at 26.6%, which is very impressive.
Recent increases have slowed as the payout ratio expanded and the dividend became bigger in absolute terms, with the most recent dividend increase being a bit over 10%.
But dividend growth is likely to accelerate once more due to the additional firepower the company is now working with.
This is a welcome change when considering the stock yields just 1.57% – a dividend growth investor needs to see lots of dividend growth to make that low yield sensible.
Still, even just 10%+ dividend growth is rather appealing on a yield of 1.5%+, as the combination of yield and dividend growth, assuming a static valuation, should roughly equal total return.
But a return to higher double-digit dividend growth makes this stock even more appealing.
With a payout ratio of just 27.4%, there’s plenty of room for very strong dividend growth for years to come – and that’s before factoring in all the extra cash that will almost certainly be allocated toward buybacks and dividends over years to come.
With all of this in mind, I wouldn’t be surprised at all to see an average of 20%+ annual dividend growth for the next decade.
We’ll now look at what kind of growth the company is actually managing across its top line and bottom line, which will help us build an expectation for that future dividend growth.
It will also help us value the business and its stock.
Now, we invest in where a company is going, not where it’s been.
But where it’s been over a very long period of time should give us some reasonable idea as to where it’s going moving forward, especially when combined with a professional forecast for near-term growth.
Apple has grown its revenue from $32.479 billion to $229.234 billion from fiscal year 2008 to fiscal year 2017. That’s a compound annual growth rate of 24.25%.
That’s an incredible growth rate, especially considering the base upon which it started.
That said, the huge numbers Apple is now working with practically guarantees a much CAGR for sales moving forward.
However, Apple doesn’t really have to register massive top-line growth like this in order to make the bottom-line and dividend growth very compelling.
Meanwhile, the company increased its earnings per share from $0.77 to $9.21 over this period, which is a CAGR of 31.75%.
The bottom line is even more impressive due to a combination of share buybacks and margin expansion.
Again, these are otherworldly numbers, but Apple could come back down to earth and still be a very fine investment.
For perspective on this, CFRA predicts that Apple will compound its EPS at an annual rate of 10% over the next three years.
This would be more in line with what we’ve seen from Apple over the last five years.
Still, this would provide for ample dividend growth, factoring in the low payout ratio and hundreds of billions of dollars that will almost surely be used to reduce the share count and simultaneously increase the dividend.
Apple’s balance sheet is obviously stellar, as hinted at earlier.
The long-term debt/equity ratio of 0.73 and interest coverage ratio of over 28 are both great metrics all by themselves, but the fact that cash and marketable securities (much of this soon to be repatriated from overseas) can pay off long-term debt multiple times over leaves no room for concern over the balance sheet.
Profitability is extremely robust, with the company sporting margins that indicate nothing less than a high-quality company with strong control over its pricing power.
Over the last five years, the company has averaged annual net margin of 21.68% and annual return on equity of 36.85%.
There’s practically nothing to dislike about this company in terms of long-term investment, which is probably why Warren Buffett has invested so heavily into it over the last year or so.
You’ve got electronic products and services that are so ubiquitous and tied into everyday life, they’re practically as necessary as a utility.
Apple is able to maintain its premium pricing and placement in the market by virtue of experience, bolstered by the fact that the products run on Apple’s own software. The seamless, high-level, and intuitive GUI is something consumers flock to, and Apple reinforces the “stickiness” of its customer base via its complementary suite of apps and services, making it difficult to switch devices.
There are, of course, risks.
Competition, technological obsolescence/changes, and the need for constant innovation are a few key considerations.
But the main issue with Apple might simply be that it’s a victim of its own success – the incredible growth rates it’s been able to deliver on in the past cannot continue indefinitely, but Apple doesn’t need to grow at 20%+ annually in order for this to be an excellent long-term dividend growth stock investment.
The valuation has come way down in comparison to its higher-flying days.
Based on that valuation, the stock looks downright appealing right now…
The stock is trading hands for a P/E ratio of 16.48, which means its a premium company/stock trading for a P/E ratio that’s well below the P/E ratio of the broader market.
And while the current basic valuation metrics (P/E, P/S, P/CF ratios, etc.) are above their respective recent historical averages, Apple wasn’t repatriating hundreds of billions of dollars a few years ago. That changes things in a big way.
So what might be a fair value for this stock as it looks today?
I valued shares using a two-stage dividend discount model analysis to account for the low yield and high near-term dividend growth rate.
I factored in a 10% discount rate, a 10-year dividend growth rate of 18%, and a long-term dividend growth rate of 7%.
The 10-year DGR is high, but I’d actually argue it’s on the conservative side when considering the amount of capital that will likely be used to reduce the outstanding share count (thus allowing for increased dividend payments on the remaining shares) and grow the dividend.
And that’s before factoring in the fact that the company looks set for 10% annual EPS growth, which could already allow for nice double-digit dividend growth with such a low payout ratio.
The DDM analysis gives me a fair value of $219.20.
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.
I find it to be a fairly accurate way to value dividend growth stocks.
So my valuation shows a stock that’s estimated to be worth much more than it’s selling for, but let’s see how my valuation compares to that of what 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 AAPL as a 3-star stock, with a fair value estimate of $170.00.
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 AAPL as a 4-star “BUY”, with a fair value calculation of $220.29.
I came out within pennies of where the latter firm landed on the valuation, but Morningstar has presented a less sanguine viewpoint. Averaging out the three numbers gives us a final valuation of $203.16, which would indicate the stock is potentially 27% undervalued here.
Bottom line: Apple Inc. (AAPL) is one of the highest-quality companies in the world. Their products are ubiquitous, bolstered by arguably an unrivaled user experience. The fundamentals are outstanding across the board. The company’s unequaled cash hoard of hundreds of billions of dollars seems likely to be largely used toward buybacks and dividends moving forward. Add in the possibility that shares are 27% undervalued, and you have one of the best long-term opportunities in the market for long-term dividend growth investors.
Note from DTA: How safe is AAPL’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 96. 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, AAPL’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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