Billions of people all over the world are consuming ubiquitous and necessary products and services every single second of every single day.
That’s a fact.
Billions of people all over the world also need to work jobs they may or may not like in order to have the money they need to live their lives and pay their bills.
That’s another fact.
Why not take advantage of the former fact so as to eliminate yourself from the latter?
Think food, energy, technology, transportation, etc.
Well, there are many fantastic, global businesses providing these products and services.
And it doesn’t take a leap of imagination to understand that they make a lot of money by doing so.
By investing in these companies, thereby taking advantage of the first fact, one can eliminate themselves from that second factual category.
If you can build enough wealth and passive income to become financially independent, you won’t need a job anymore.
Even a regular, everyday person can save and invest their way toward financial independence.
I proved that out myself by going from an unemployed, indebted, 20-something college dropout in 2009 to financially free at the age of 33, in early 2016.
My Early Retirement Blueprint recounts that entire journey.
That “blueprint” lays out a path that almost anyone can follow to their own early retirement dreams.
There are two main components of that blueprint.
First, I saved over half my net income for years by adopting a frugal lifestyle.
Second, I invested the savings into the companies that are providing the world with those aforementioned ubiquitous and necessary products and services.
The result of that is my FIRE Fund, which is a six-figure, real-life, and real-money dividend growth stock portfolio.
This portfolio generates the five-figure and growing passive dividend income I need to pay my bills, which allowed me to excuse myself from that second factual category.
Those companies that almost quite literally allow the world to go round not only make a lot of profit, but they often share that profit with their shareholders in the form of dividends.
And as their profit grows (which tends to happen when you’re providing more necessary products/services at rising prices to a growing global population), so do those dividend payments.
That’s dividend growth investing in a nutshell.
As such, there’s no need to stretch your imagination out for what I’m going to tell you next.
High-quality dividend growth stocks are some of the best stocks in the world.
And since no other asset class (to my knowledge) has performed as well as stocks over the last century, it makes sense to home in on the best stocks of all.
You can find more than 800 US-listed dividend growth stocks via David Fish’s Dividend Champions, Contenders, and Challengers list – a list which has compiled incredible data on stocks that have raised dividends each year for at least the last five consecutive years.
All that said, however, one shouldn’t just pick random dividend growth stocks off of Mr. Fish’s list and buy them at random times.
Fundamental analysis, understanding competitive advantages, weighing out risks, and valuation are all critical steps to perform before buying any dividend growth stock.
And it’s that last point – valuation – that is particularly relevant.
Even the best business can be a poor investment, especially over the short term, if an investor pays too high a price for the stock.
Price is what something costs, but value is what something is worth.
Being able to discern between the two is very important.
If you’re able to buy a high-quality dividend growth stock when it’s undervalued, you’re tilting some very favorable dynamics in your favor.
An undervalued dividend growth stock should offer an investor 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.
Price and yield are inversely correlated; all else equal, a lower price will result in a higher yield.
That higher yield allows for greater long-term total return potential right from the get-go, because total return is comprised of investment income (through dividends or distributions) and capital gain.
Since reinvested dividends make up the bulk of the stock market’s long-term total return, a higher yield (rather than a lower yield) is obviously very appealing, and it sets you up well for the long haul.
And capital gain is also given a possible boost via the “upside” that exists between a lower price paid and higher intrinsic value.
While price and value can be wildly disconnected in the short term, price tends to more closely correlate with value over the long term.
If you’re able to buy a stock when the two are favorably disconnected, that sets you up for additional capital gain on top of whatever organic capital gain was/is possible as a business naturally becomes worth more over time (as it sells more products and/or services, increasing its profit).
These favorable dynamics have a way of reducing risk, too.
That’s because you’re laying out (risking) less capital per share.
As such, you’re introducing a margin of safety that protects your downside (an investment ending up worth less than you paid) in case an investment thesis goes awry.
Fortunately, these favorable dynamics aren’t that difficult to catch and take advantage of.
But being able to estimate intrinsic value before you invest is necessary.
That’s where fellow contributor Dave Van Knapp’s guide to valuation comes in.
Lesson 11: Valuation is the 11th lesson in an overarching series of lessons designed to educate investors on all things dividend growth investing.
It’s this lesson that focuses on valuation in particular. And it’s a fantastic tool to help simplify the valuation process.
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…
PPL Corp. (PPL) is an energy and utility holding company that, through its subsidiaries, generates and markets electricity in the northeastern and western US and delivers electricity in Pennsylvania and the UK.
It operates in the following segments: Kentucky Regulated, 42% of fiscal year 2017 revenue; UK Regulated, 29%; Pennsylvania Regulated, 29%.
Serving more than 10 million customers in both the US and the UK, PPL undoubtedly provides one of those aforementioned ubiquitous and necessary services to people: energy.
We can’t live our modern-day lives without the energy a company like PPL provides.
And investing in this practical necessity is a great way to build the growing passive income one needs to become financially independent.
A utility stock can provide a safe, growing, and big dividend.
As for safety, consider that PPL has a dividend history dating back to at least the 1940s.
And the dividend is currently backed by a payout ratio of 76.6%. (using adjusted TTM EPS that factors out tax reform impacts for Q4 2017).
While a touch high, it’s not out of line for a utility. Utilities usually pay out a significant portion of their earnings in the form of a dividend due to the very business model.
As for growth, that’s been proven out by the fact that PPL Corp. has increased its dividend for 17 consecutive years.
In fact, the company announced its most recent dividend increase just a few months ago.
And management has explicitly stated that it’s committed to dividend growth, which should be backed by the growth projection of 5% to 6% compound annual earnings growth from 2018 to 2020.
Looking at the historical record, the dividend has grown at an annual rate of 3.3% over the last 10 years.
The most recent dividend increase was in that range. And I think that should be a baseline expectation moving forward.
While not massive growth, we have to consider the sheer size of this dividend.
The stock currently yields 6.07%.
That’s a massive yield that’s well in excess of not just the broader market, but it’s also quite a bit higher than the utility sector as a whole.
In addition, that yield is more than 140 basis points higher than the stock’s own five-year average yield.
That sums up the safety, growth, and bigness of the dividend pretty well.
Of course, the dividend is just one aspect of a stock.
Moreover, we have to have a good idea as to what kind of overall growth a business can generate in order to estimate the intrinsic value of a stock, which is hinged on future growth (of cash flow or dividend income) that’s discounted back to today.
So we’ll next look at PPL Corp.’s last decade in terms of top-line and bottom-line growth, before lining that up against a near-term expectation for profit growth.
Seeing the known past and estimated future in this fashion should allow us to start to draw conclusions about the company’s earnings growth potential going forward.
And that in turn tells us a lot about what we might be looking at in terms of dividend growth moving out into the future.
The company’s revenue has been almost static over the last ten fiscal years, moving from $8.007 billion to $7.447 billion between fiscal year 2008 and fiscal year 2017.
Utility companies naturally have limited growth opportunities. They’re geographically landlocked most of the time. Regulation further constrains them.
However, PPL Corp.’s ten-year top-line growth has been impacted by the 2011 acquisition of the Central Networks electricity distribution business in the UK, the 2015 spin-off of its competitive energy business, and the significant devaluation of the pound.
The bottom line follows a similar trajectory: earnings per share went from $2.47 to $2.25 (using adjusted EPS for FY 2017 that factors out tax reform impacts) over the last decade.
I’d prefer to see low-single-digit bottom-line growth from a mature utility like this, but PPL’s geographic footprint and reshuffling of its business has made this a bit difficult.
Moving forward, though, the picture looks a bit brighter.
CFRA believes PPL Corp. will compound its EPS at an annual rate of 4% over the next three years, which would actually fall a bit short of management’s growth projection that was cited earlier.
That growth projection is underpinned by plans to invest $15 billion in infrastructure through 2022. This should, in turn, drive rate base growth.
But even if growth comes up short, falling somewhere closer to where CFRA is pinning it, the dividend should still be able to grow at a rate that’s similar to the demonstrated 10-year growth rate.
And that would be on top of that massive yield. So there’s certainly a lot to like here about the dividend.
Moving over to the balance sheet, PPL Corp. is unsurprisingly (for this industry and business model) leveraged.
The long-term debt/equity ratio is sitting at 1.84, while the interest coverage ratio is a bit over 3.
These are numbers that are neither excellent nor terrible, but the interest coverage ratio has been negatively impacted by the hits to GAAP net income from tax reform. Otherwise, it’d be closer to 4.
Profitability, meanwhile, is relatively robust. It’s just as good as some of the better utility companies out there.
Over the last five years, PPL Corp. has averaged annual net margin of 14.74% and annual return on equity of 11.77%.
The reported numbers have been a little volatile from year to year, but the long-run average is pretty strong.
What we really have here, in my view, is a very solid utility company that offers all of the benefits and drawbacks that a utility could, except PPL Corp. is a little unique with its geographical footprint.
You have a ubiquitous and necessary service that is protected by local monopolies. People need energy, which compels them to use PPL Corp. (when and where applicable). And the rates PPL Corp. can charge are backed by the government, which is a situation that’s partially boosted by investment. It’s a cash cow that’s practically guaranteed.
However, all of that is moderated by regulation, geographical growth limits, the constant need to invest in infrastructure (which also benefits a utility to a degree), rising interest rates, and the shifts to cleaner energy sources.
PPL Corp.’s unique footprint has probably harmed the stock more than it’s helped it, especially of late.
That’s due to to the company’s exposure to the UK: there’s Brexit, a weakening pound, and the potential of price capping in the UK.
But it’s important to note that PPL only provides transmission – not generation – in the UK.
Still, I think this stock has been undeservedly beat down, putting it in undervalued territory…
The P/E ratio (using adjusted TTM EPS) is sitting at right about 12.62. That’s well below the broader market. Furthermore, that compares quite favorably to the stock’s own five-year average P/E ratio of 15.4.
Investors are also paying much less for the cash flow of the business today than they what they willing to pay, on average, over the last three years.
And the yield, as noted earlier, is substantially higher than its own five-year average.
The stock does look cheap. But how cheap? What would an estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3.25%.
That long-term DGR is below the demonstrated dividend growth from this company over the last decade. It’s also below the most recent dividend increase. And I’m also considering the forward-looking EPS growth rate of the business, which should support like dividend growth.
I think this is a conservative look at future dividend growth potential, but I’d rather err on the side of caution with an estimate.
The DDM analysis gives me a fair value of $35.65.
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 what I believe was a very fair, if not conservative, look at the valuation, the stock looks to be extremely undervalued.
Of course, my perspective is but one of many when it comes to this stock and its valuation.
We’ll now look at what two professional analysis firms have come up with as it pertains to this stock’s value.
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 PPL as a 4-star stock, with a fair value estimate of $35.00.
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 PPL as a 5-star “STRONG BUY”, with a 12-month target price of $35.00.
Wow. You can’t get more consistent than that. We all agree that this stock is worth about 35 bucks. Averaging the three numbers out gives us a final valuation of $35.25, which would indicate the stock is potentially 31% undervalued right now.
Bottom line: PPL Corp. (PPL) provides a necessary and ubiquitous service to millions of captive consumers, all in a monopolistic setting. That allows them to pay a huge, reliable, and growing dividend to yield-hungry investors. With improving fundamentals, a 6%+ yield, 17 consecutive years of dividend raises, and the potential that shares are 31% undervalued, this dividend growth stock could electrify your portfolio.
— Jason Fieber
Note from DTA: How safe is PPL’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, PPL’s dividend appears safe and unlikely to be cut. Learn more about Dividend Safety Scores here.
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