The US stock market is one of the biggest and best wealth creators that’s ever existed in human history.
To not take advantage of it on a regular basis seems silly to me.
However, there’s a right way to do that… and a wrong way.
Trying to dance in and out of that market, trading stocks regularly, is definitely the wrong way.
Just sit back and try to name five really successful stock traders who made a lot of money, over a long period of time, trading stocks (and not selling books or courses on how to trade stocks).
But I can name dozens of highly successful long-term investors who have gone on to create fortunes for themselves and others.
Maybe the name Warren Buffett rings a bell.
Yeah. Probably the world’s most successful long-term investor of all time. An owner.
Indeed, the right way to take advantage of the US stock market’s immense wealth creating features is to become an owner, not a trader.
That means you buy stocks and then hold them for the long run, benefiting as great businesses go on to become bigger and better.
You should think of stocks not as pieces of paper to trade like baseball cards, but rather they’re equity in real businesses that have real employees working to ensure real profit.
And you know what else is real?
The dividends that many of these businesses pay.
Not only dividends – growing dividends.
It’s the simple and long-term investing strategy of dividend growth investing that has literally changed my life.
I was a broke, unemployed, college dropout in 2009.
And then I was financially independent and retired in early 2016 – at the age of 33.
I discuss how that process played out via my free Early Retirement Blueprint, which almost anyone can follow to their early retirement dreams.
But a key aspect of the journey was dividend growth investing, which essentially involves investing in high-quality businesses that pay their shareholders increasing dividends.
That strategy helped me build my FIRE Fund – a real-life and real-money dividend growth stock portfolio that is generating five-figure and growing passive dividend income I need to cover my basic expenses in life.
You wouldn’t want to invest in a company that can’t grow profit. And you should expect your rightful share of that rising profit as a shareholder.
Thus, dividend growth stocks.
It’s a strategy that’s intuitive. Better yet, those growing dividends are a fantastic source of increasing passive income.
You can find more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years via David Fish’s Dividend Champions, Contenders, and Challengers list.
However, it’s not as easy as picking random stocks off of Mr. Fish’s CCC list and buying them.
You should do your due diligence, making sure to understand a business and comb through its financials to make sure the fundamentals and competitive advantages are acceptable. You want to own a quality business for the long run.
And perhaps just as important, you should aim to pay the right price for a high-quality dividend growth stock.
The right price is, of course, one that’s as far below estimated intrinsic value as possible.
Said another way, it behooves the long-term investor to buy up high-quality dividend growth stocks when they’re undervalued.
An undervalued dividend growth stock should present an investor a higher yield, greater long-term total return potential, and less risk.
That’s relative to what the same stock might otherwise offer if it were fairly valued or overvalued.
Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.
That higher yield should translate into more passive investment income – both in the short term and long term.
But it should also translate into greater long-term total return potential, due to the very nature of total return.
Total return has two components: investment income and capital gain.
We can see how the former should be greater right from the start.
However, capital gain is also given a possible boost via the “upside” that exists between a lower price and higher intrinsic value.
While the stock market might not fully realize a stock’s worth and price it appropriately at any given moment in time, price and value do tend to more or less converge over the long run.
If you’re able to take advantage of any significant “mispricing” in the short term, that could lead to massive additional capital gain over the long term.
And that’s on top of whatever organic capital gain is/was possible as a company naturally becomes worth more in time if/when it increases its profit.
These dynamics also reduce risk.
Paying less (rather than more) for the same stock risks less capital on a per-share basis.
And increasing upside has a way of simultaneously reducing downside, via the introduction of a margin of safety that protects an investor from being “upside down” on an investment in case something goes wrong or the valuation estimation is off.
One might assume that valuing a dividend growth stock is a difficult exercise.
However, that’s not necessarily the case at all.
Fellow contributor Dave Van Knapp has put together a series of lessons on dividend growth investing as a whole, designed to educate investors on how the strategy works, why it’s so great, and how to successfully implement it for their own goals.
Well, his DGI Lesson 11: Valuation specifically discusses valuation, and it’s extremely insightful for that purpose.
With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…
AT&T Inc. (T)
AT&T Inc. (T) is a holding company that provides domestic and international communication and entertainment services.
I’d argue that society has an addiction to mobile phones.
Smartphones are ubiquitous. And they’re practically as integral to modern society as electricity or indoor plumbing.
As such, the companies that benefit from and enable this relationship between people and their smartphones can represent excellent long-term investment opportunities.
AT&T is such a company.
See, those smartphones are rendered useless without access to mobile data.
Well, there are only a few large companies in the entire country of the US that provide high-quality mobile data.
In fact, there are only two massive players, with AT&T being one and Verizon Communications Inc. (VZ) being the other.
We have the makings of a duopoly here, which is fantastic.
That’s because you have a service that people basically cannot live without. And you only have two big players providing most of that service’s availability.
Moreover, access to networks will only become more necessary, valuable, and ubiquitous in the future as the Internet of Things takes hold. This is especially true with 5G leading the next revolution in communications and technology.
Everything from our phones, cars, houses, and even potentially our bodies will be communicating with each other, across networks, in the future.
If that’s not enough to like, companies like AT&T have swiftly and decidedly moved further into content.
Content is king right now. And companies that can produce high-quality content are set to own media. Companies that distribute that content are almost as important, although perhaps more exposed to disruption.
Well, AT&T is looking to be vertically integrated across content production and distribution through the announced (but in limbo) acquisition of Time Warner Inc. (TWX), which would reshape the company into a formidable content producer with a number of major cable network channels and one of the largest movie studios in the world.
Due to the nature and necessity of mobile data, the regulation in the industry, the need for constant and expensive investment in a network, geographic expansion limitations, market saturation, and the limited competitors for consumers, communication companies like AT&T look and operate a lot like a traditional electric utility company.
And the stock looks a lot like a utility stock.
I’ll break that down.
You have the high yield, which is characteristic of a utility.
AT&T’s stock offers an eye-popping yield of 6.14%.
That’s well over twice the broader market. It’s also more than 100 basis points higher than the stock’s own five-year average.
And while many utility stocks offer higher-than-market yields, getting over 6% with a utility is really rare.
That yield is offered with a rare combination of security and growth.
The company has increased its dividend for 34 consecutive years.
That’s blue-chip stuff right there.
And the dividend’s 10-year growth rate stands at 3.3%.
Sure, not massive growth. But it’s at least keeping in line with inflation – and that’s on top of that yield near 6%.
You don’t really need much growth to make a 6%+ yield worth the stretch in this environment. And interest rates have a long way to climb before that dynamic becomes less appealing or interesting.
With a payout ratio sitting at 75.5% (after factoring out a large one-time gain in Q4 2017), the dividend appears to be quite safe and sustainable.
We’ll next move into company growth, which will tell us a lot about what to expect for future dividend growth (business and dividend growth should roughly match each other over the long run).
And this will in turn give us a lot of information we need to estimate the intrinsic value of the business and its stock.
The last decade will be used as a proxy for the long term. Furthermore, that period includes numerous large transitions for the company, as well as the Great Recession. A challenging and changing time frame like the last ten years is great for “stress testing” a company’s long-term durability and true growth potential.
AT&T increased its revenue from $124.028 billion to $160.546 billion between fiscal year 2008 and FY 2017. That’s a compound annual growth rate of 2.91%.
This is right about what I’d expect for a large and mature company like AT&T.
I usually look for mid-single-digit top-line growth from a mature company, but AT&T’s massive size (they started this period at well over $100 billion in revenue) lowers those expectations a tad.
This level of growth is pretty acceptable; however, keep in mind that even the sub-3% growth was bolstered a bit by the recent acquisition of DirecTV.
Meanwhile, the company grew its earnings per share from $2.16 to $3.05 over this period, which is a CAGR of 3.91%.
As a note, I used adjusted EPS for FY 2017, due to AT&T recording a large one-time gain for FY 2017 that isn’t material to actual profit or growth.
We see bottom-line growth that’s roughly in line with dividend growth over this same stretch, which is what one should anticipate.
EPS growth and dividend growth should continue to roughly mirror each other moving forward considering this business model and the payout ratio.
For context on that forward-looking expectation, CFRA believes AT&T will compound its EPS at an annual rate of 8% over the next three years.
I personally don’t see that kind of bottom-line acceleration occurring for AT&T, nor would investors need to see it in order to make AT&T an attractive long-term investment in terms of aggregate dividend income.
Growth coming in at half that mark would be similar to that of which occurred over the last decade – and that would allow for similar (~4%) dividend growth.
The company’s balance sheet is leveraged, but I don’t think it’s abnormal or particularly concerning for the business model.
This is a capital-intensive business model that’s similar to a utility, and I don’t think AT&T is out of line relative to its peers.
The long-term debt/equity ratio is 0.89, while the interest coverage ratio is over 3.
Profitability is more than suitable. I’d actually argue AT&T’s net margin is fairly robust considering the fact that the core mobile communication business model is competitive (among the limited players), saturated, and even somewhat commoditized.
Over the last five years, the company has averaged annual net margin of 10.84% and annual return on equity of 14.51%.
Dividend growth investors looking for a big and reliable dividend that’s at least keeping pace with inflation can do a lot worse than AT&T.
In fact, there are very few options out there for a 6%+ yield that’s also safe and growing.
And if/when the Time Warner acquisition closes, AT&T will be fundamentally even better than it already is, and it’ll be vertically integrated with dynamics and scale that no other company will match.
Of course, regulation, competition, the constant need to reinvest in the network are all risks that should be considered.
But with the valuation where it’s at, this stock looks very attractive right now…
The P/E ratio (based on TTM EPS that uses adjusted Q4 2017 earnings) is sitting at 12.30.
That obviously compares very favorably to a broader market that’s well over 20. And that’s also well below the stock’s own five-year average P/E ratio of 21.2 (although that is distorted by numerous one-time gains/losses on GAAP EPS).
And the yield, as noted earlier, is more than 100 basis points higher than its five-year average.
Everything is pointing to undervaluation, but by how much might this stock be undervalued? 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%.
That DGR is below both the company’s long-term EPS growth rate and dividend growth rate, but I’m erring on the side of caution here.
If anything, AT&T could very well (and likely will) deliver a better result than this over the long haul.
Even if they don’t, though, this builds in a margin of safety.
The DDM analysis gives me a fair value of $41.20.
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.
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.
Even with a fairly conservative look at the stock, it appears to be worth more than it’s currently trading for.
But let’s compare my valuation with that of what two professional analysis firms have come up with, which should add plenty of perspective to the conversation.
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 T as a 4-star stock, with a fair value estimate of $40.00.
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 T as a 4-star “BUY”, with a fair value calculation of $44.25.
There’s a fairly tight spread here, indicating a consensus. Averaging the three numbers out gives us a final valuation of $41.82, which is very close to where I came out. That would indicate the stock is potentially 28% undervalued.
Bottom line: AT&T Inc. (T) is a high-quality company that provides a range of services that aren’t only ubiquitous, but these services are set to be even broader and more ubiquitous moving forward. That means a lot of profit. And they’re sharing that profit with their shareholders via a big, safe, and growing dividend. With a 6%+ yield, more than 30 consecutive years of dividend growth, and the possibility that shares are 28% undervalued, this is a compelling long-term dividend growth stock investment right now.
Note from DTA: How safe is T’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. 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, T’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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