I remember having this vision many years ago, probably during one of my tougher days at the old day job.
The vision involved myself, in a bath robe, walking out to the mailbox in the late morning to collect my most recent dividend check.
Approving of that check with a nod and a smile, I walk back into my apartment to take a shower and get ready to enjoy my day.
Well, that dream is now reality, folks.
I’m only in my mid-30s, yet I’m living off of the passive dividend income my real-life and real-money FIRE Fund generates.
But reality is better than the dream.
I don’t even have to walk out to a mailbox, collect a check, or worry about heading down to the bank.
Dividends are electronically deposited into my account, cutting out whatever little “work” might actually be involved in the process. It doesn’t get any more passive than that.
I actually went from below broke at 27 years old to FIRE at 33 years old – and I even shared that entire journey in my Early Retirement Blueprint.
That journey was largely dependent on the investment strategy that I settled on, which I still use to this day.
That strategy is dividend growth investing.
Dividend growth investing simply involves buying up equity in world-class businesses that directly share their growing profit with their shareholders, in the form of growing cash dividend payments.
That dream can be your reality, too!
You can find almost 900 US-listed examples by checking out the Dividend Champions, Contenders, and Challengers list, which has compiled data on stocks that have raised their dividends each year for at least the last five consecutive years.
That source of knowledge and data is great, but you still have to analyze a business – looking at fundamentals, qualitative aspects, risks, and valuation.
That last part is in boldface because it’s really imperative that you pay the right price for a high-quality dividend growth stock.
What’s the right price?
Well, it’s one that is as far below estimated intrinsic value as possible.
When you have that favorable disconnect between price and value, you’re looking at an undervalued stock.
And this can have a major positive impact on your investment over the long term.
An undervalued dividend growth stock should present you with a higher yield, greater long-term total return potential, and less risk.
That’s all relative to what that same stock might otherwise present 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 goes on to present you with greater long-term total return potential because total return is comprised of two components: investment income (via dividends or distributions) and capital gain.
In addition, that second component, capital gain, is given a possible boost via the “upside” that exists between the lower price paid and higher estimated intrinsic value.
If you pay $50 for a stock that’s deemed to be worth $75, you have $25 worth of “upside” that could manifest itself, which would be capital gain that’s on top of whatever capital gain is naturally likely as a high-quality company increases its profit and becomes worth more in the process.
While the stock market isn’t necessarily very good at accurately pricing stocks over the short term, price and value do tend to more closely correlate over the long term.
Of course, this all goes a long way toward lessening risk.
It’s obviously less risky to pay less money for the same asset.
Whether it’s a stock or a house, you’re always better off paying less money for the same exact asset.
And when you’re investing in a dividend growth stock, you introduce a margin of safety when you pay much less than the stock is estimated to be worth.
A margin of safety is always something you want because intrinsic value is an estimate, and any number of unforeseen events and factors could end up reducing the value of a company in the future – management missteps, new competition, additional regulation, etc.
These favorable dynamics that are provided when undervaluation is present are obviously appealing.
But taking advantage of them first requires being able to reasonably estimate fair value so that you can identify undervalued dividend growth stocks from the start.
Fortunately, we have a fantastic resource that’s designed to greatly aid you in that process.
Fellow contributor Dave Van Knapp put together a series of lessons that holistically educate investors on dividend growth investing – how it works, why it’s so great, and how to successfully implement it in your own life.
One particular lesson focuses specifically on what we’re talking about here.
It’s Lesson 11: Valuation.
And it’s very much worth a read.
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…
United Parcel Service, Inc. (UPS)
United Parcel Service, Inc. (UPS) is the world’s largest parcel delivery company, using more than 500 planes and 100,000 vehicles to deliver millions of packages to residences and businesses worldwide.
Fiscal year 2017 revenue broke down via the following three segments: US Domestic Package, 62%; International Package, 20%; and Supply Chain & Freight, 18%.
If we know anything about where the future is headed, we know that the world is becoming increasingly digital.
People and businesses are relying more on smaller transactions that are handled at the individual level.
This is never more apparent than in retail, which has seen its landscape shift rather dramatically over the last five or so years.
With more people shopping online, rather than at large stores, there are more “micro transactions” occurring at the individual level, meaning these small packages are going out to all of these individuals, rather than the old model of large shipments landing at larger retail centers.
As such, companies that handle packages and deliveries appear poised to do incredibly well moving forward.
With UPS being the world’s largest such company, it would seem they’re positioned almost perfectly.
That also positions their dividend almost perfectly, which is great news for dividend growth investors.
As it sits, UPS has increased its dividend for nine consecutive years, with a five-year dividend growth rate of 7.8%.
It’s worth noting that the dividend growth rate has been pretty consistent over the last nine years, other than showing some recent acceleration – the most recent dividend increase came in at almost 10%.
And with a yield of 3.05%, there’s plenty of income to be had, which is on top of that really strong dividend growth.
That yield, by the way, more than 30 basis points higher than the stock’s five-year average yield. It’s also quite a bit higher than the broader market.
If you can get a yield of 3%+ and dividend growth of 7%+, assuming a static valuation, you’re setting yourself up for a double-digit annual total return.
That’s kind of the “sweet spot” of dividend growth investing, in my opinion – there’s no real sacrifice in either yield or growth here.
The payout ratio is fairly reasonable, too, at just 61.2%.
Of course, in order to estimate future dividend growth, we need to estimate future business growth.
A company in stasis can’t continue growing its dividend for very long.
So we’ll next look at what UPS has done over the last decade in terms of top-line and bottom-line growth, and then we’ll compare that to a near-term professional forecast for profit growth.
Blending the known past and an approximation of the future in this manner should tell us a lot about where UPS is going as a business, which will in turn tell us a lot about where the dividend might go.
All of this information will also greatly aid us when it comes time to value the company and its stock.
UPS has increased its revenue from $51.486 billion in FY 2008 to $65.872 billion in FY 2017. That’s a compound annual growth rate of 2.78%.
Not fantastic top-line growth here (I’d like to see something closer to at least 4%), but we have to keep in mind that UPS is quite exposed to the global economy (especially in the US). Less people buying things means less packages need to be delivered. The Great Recession greatly impacted this company’s revenue and profit during the early part of this period, which saw UPS start to get back in gear around FY 2011.
Meanwhile, earnings per share advanced from $2.94 to $5.61 over this same 10-year stretch, which is a CAGR of 7.44%.
That’s right in line with dividend growth, which shows a certain level prudence and consistency on the part of management.
Much of this excess bottom-line growth was driven by share buybacks: UPS reduced its outstanding share count by just over 14% over the last decade.
To grow EPS at ~7.5% annually over an incredibly difficult period of time is, in my view, actually solid.
Moving forward, CFRA predicts that UPS will compound its EPS at an annual rate of 12% over the next three years, citing improved volumes from e-commerce, pricing improvement, and infrastructure spending (which the company has laid out after benefiting from a lower tax rate due to the passage of the 2017 Tax Cut and Jobs Act). Since UPS does about 80% of its business domestically, the lower tax rate should be a boon.
UPS wouldn’t have to grow EPS at 12% annually in order to be an appealing investment here, nor would they have to grow the bottom line at that kind of rate in order to deliver very worthwhile dividend growth to shareholders.
An expansion of the payout ratio doesn’t seem prudent, but EPS growth of something even close to what they’ve already delivered over the last decade (over a very challenging time period) would allow for high-single-digit dividend growth.
That said, some kind of acceleration in bottom-line growth (and thus dividend growth) seems likely, due to the confluence of benefits that are lining up for them: they’ve moved past a difficult economic period, should benefit from huge trends taking over, and the lower tax rate should be disproportionately advantageous.
The company’s balance sheet paints a mixed picture, mostly because low common equity inflates the long-term debt/equity ratio beyond what would ordinarily be considered a reasonable range.
Drilling down into that, the long-term debt/equity ratio is 19.69.
However, long-term debt is sitting at only about 20% of the company’s market cap. Furthermore, the interest coverage ratio, at over 16, is actually quite high for a capital-intensive business like this.
Profitability is solid, with the firm averaging annual net margin of 6.90% and annual return on equity of 259.34% over the last five years.
ROE has been inflated due to the aforementioned low common equity, but net margin has shown some signs of expansion in recent years.
Overall, there’s a lot to like about this business.
It’s the biggest player in an industry that essentially operates as a global oligopoly. Domestically (which is where most of the business currently is), UPS operates in a duopoly. Due to how much capital is necessary to start and run a business like this, the current players are firmly entrenched.
With long-term trends pointing to more volume, UPS simply has to manage its pricing. With numerous competitive advantages (scale being the most notable), this shouldn’t be difficult.
That said, the firm will have to right-size its offerings and pricing while it continues to invest and build out.
They’re positioned about as well as a company can be in terms of taking advantage of trends in shopping and shipping, and that positioning will improve as they grow their capacity and infrastructure.
Of course, there are risks to consider: competition (albeit limited right now), a fast-changing retail landscape, and the need to right-size the company and its pricing while it adapts to changes. But the risks appear low, especially against the long-term potential.
At the right valuation, this could be a fantastic investment.
Well, I think the valuation just so happens to be pretty appealing right now…
The stock is trading hands for a P/E ratio of 20.16. That’s lower than the broader market, and it’s about half of the stock’s own five-year average P/E ratio (with that average being skewed by hits to GAAP earnings).
The multiple on revenue is lower than its five-year average.
And the yield, as noted earlier, is more than 30 basis points higher than its recent historical average.
So the stock doesn’t look outrageously cheap, but the price and value do seem to be disconnected. How large might that disconnect be?
I valued shares using a dividend discount model analysis.
I factored in a 10% discount rate and a long-term dividend growth rate of 7.5%.
That DGR is in line with the long-term demonstrated dividend and EPS growth rate. And the business is very stable.
While I’m assuming an acceleration of EPS growth will allow for an acceleration in dividend growth (evidenced by the most recent dividend increase); I like to err on the side of caution here. As such, I’m basically moving a challenging past into the future, which should build in a margin of safety in this model. Furthermore, the payout ratio is slightly elevated.
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.
Again, the stock doesn’t appear to be incredibly cheap, but it does appear to be a high-quality business with numerous tailwinds and advantages working in its favor that’s available at a discount. There’s nothing wrong with that.
Of course, my perspective is but one of many, which is why I like to show what professional analysts are coming up with in regard to the valuation. This adds depth and balance to our bottom line.
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 UPS as a 3-star stock, with a fair value estimate of $113.00.
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 UPS as a 5-star “STRONG BUY”, with a 12-month target price of $155.00.
Averaging the three numbers out gives us a final valuation of $141.51, which would indicate the stock is potentially 18% undervalued right now.
Bottom line: United Parcel Service, Inc. (UPS) is a high-quality company that operates in a domestic duopoly. Numerous tailwinds and strengthening competitive advantages make the business model even more appealing moving forward. With a 3%+ yield, high-single-digit dividend growth, and the possibility that shares are 18% undervalued, dividend growth investors may want to consider shipping this stock into their portfolios.
Note from DTA: How safe is UPS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 75. 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, UPS’s dividend appears safe and very unlikely to be cut. Learn more about Dividend Safety Scores here.
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