One of the greatest investors to ever live is Peter Lynch.
He averaged annual returns of 29% for 13 years, from 1977 to 1990.
It might seem like that kind of investment return would require unique insight or a complicated strategy.
Well, that’s not true at all.
In fact, Lynch has often recommended an investment exercise that’s extremely simple.
That strategy is this: take a look all around you for investment opportunities.
It doesn’t take any kind of special insight to see the products and services that make the world go round.
And this idea is at the heart of the investment strategy I personally use.
That strategy is dividend growth investing.
Just take a look at the Dividend Champions, Contenders, and Challengers list.
That list contains data on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
Guess what you’ll find on that list?
Yep. Just what Lynch has talked about. The companies that provide the products and services all around you.
This strategy is great in part because of its simplicity.
If you can build a diversified portfolio full of high-quality dividend growth stocks, you could become financially free.
That’s because you could put yourself in the position to live off of growing dividend income.
People like to talk about the “American Dream”.
There’s no better American Dream than living off of dividends.
To that end, I spent six years of my life living well below my means and aggressively investing my savings into high-quality dividend growth stocks.
And I went from below broke at 27 years old to financially free at 33!
I’ve shared that entire journey, with every step along the way, in my Early Retirement Blueprint.
My FIRE Fund, which is my real-life and real-money dividend growth stock portfolio, now generates the five-figure dividend income I need to cover my essential expenses in life.
But I didn’t build that Fund by randomly buying dividend growth stocks.
I aimed to buy shares in the best businesses in the world, when the valuations were appealing.
That’s because price is what you pay, but value is what you actually get for your money.
When the former is well below the latter, you’re putting yourself in a great spot.
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 present 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 leads to greater long-term total return potential.
Total return is comprised of capital gain and investment income (via dividends or distributions). A higher yield leads to more investment income on the same invested dollar.
This is before factoring in the “upside” that could lead to greater capital gain, since a short-term favorable disconnect between price and value could, and may very well, correct itself over time.
All of this should reduce risk, too.
That’s because you introduce a margin of safety when you pay a price well below estimated intrinsic value.
Just in case something goes wrong with the investment thesis, you protect yourself against possible downside when there’s a sizable buffer.
Like Lynch’s recommendation to look around you for investment ideas, paying less than fair value for a great asset is a pretty simple concept to understand.
Fortunately, it’s also fairly straightforward to actually execute.
Fellow contributor Dave Van Knapp has made that execution process even easier.
He put together a great valuation system for you readers.
It’s part of an overarching series of articles designed to teach the dividend growth investment strategy.
You can find that system in Lesson 11: Valuation.
It’s absolutely worth a read.
And it discusses the importance of valuation with even more depth.
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)
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 provides ubiquitous and necessary energy services to people.
So Lynch has talked about looking all around you for great investment ideas.
I can’t imagine something more obvious than energy.
It’s everywhere. Without our lights, electricity, and modern HVAC systems, society is much different (and worse).
This is an extremely simple investment thesis.
It’s also very profitable.
And just like the electricity they provide, you can actually see that profit.
That’s because PPL pays a big and growing dividend. The big and growing dividend is funded by their growing profit. Growing profit is secured by providing a necessary and ubiquitious service.
This is money in your pocket. It’s the “proof in the profit pudding”, if you will.
PPL has paid an increasing dividend for 17 consecutive years.
That’s a track record that puts them right up there with some of the biggest and best utilities out there.
It also stretches right through the financial crisis, which is a tough test for any business.
But even in tough economic times, people still need electricity.
Along with that certainty, the stock pays a hefty yield of 5.23%.
That’s a lot of income, especially in today’s environment.
This yield is also more than 50 basis points higher than the stock’s own five-year average yield.
It’s not just yield, though; the 10-year dividend growth rate of 3.3% means that PPL is committed to making sure shareholders are looking at more income year and in year out.
That helps fight off inflation.
And with a payout ratio of 64.3% (using adjusted TTM EPS that factors out a one-time Q4 2017 tax charge), this big dividend appears safe and secure.
But we invest in where a company is going, not where it’s been.
So we’ll attempt to gauge the company’s future profit growth, which will more or less guide the dividend growth.
In order to gauge that, however, we’ll need to take a look at the company’s long-term top-line and bottom-line growth.
This will tell us what kind of enterprise PPL is running.
And we’ll compare that to a near-term professional forecast for EPS growth.
Combining the known past with the estimated future in this manner should help us build out our growth expectation, which in turn helps us value the business.
The company’s revenue is basically flat over the last decade, going from $8.007 billion to $7.447 billion between fiscal year 2008 and fiscal year 2017.
I would never expect a utility to deliver outstanding revenue growth.
Utility companies are naturally limited by geography and regulation.
However, PPL has been particularly 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 over this period.
Earnings per share growth looks similar, moving from $2.47 in FY 2008 to $2.25 in FY 2017.
I used adjusted EPS for FY 2017 due to the significant one-time tax charge the company took, which is immaterial to earnings power.
In my opinion, it’s prudent to look for low-single-digit revenue and profit growth from a utility.
While PPL didn’t deliver that here, the company’s unique geographic footprint and the reshuffling of certain operations means it’s difficult to judge them by these numbers.
The near-term future does look quite a bit brighter, however.
CFRA is predicting that PPL will compound its EPS at an annual rate of 4% over the next three years.
The analysis firm calls out PPL’s customer growth and rate increases as opportunities.
But it may actually be on the low side.
Per the Q3 2018 earnings press release, the company had this to say about earnings growth:
“The company continues to expect 5 to 6 percent compound annual earnings growth per share from 2018 through 2020 off of its original 2018 ongoing earnings forecast midpoint of $2.30 per share.”
Either way, dividend growth investors are set up nicely here.
With a modest payout ratio and 4-6% EPS growth moving forward, it’s not unreasonable to expect annual dividend raises in the 4% range for the foreseeable future.
One issue to point out, though, is the balance sheet.
A high amount of leverage is present. This is common for a utility.
The business model is asset heavy, but it’s also secured by reliable cash flow.
The long-term debt/equity ratio is sitting at 1.84. And the interest coverage ratio is just over 3.
These numbers aren’t especially impressive, but they’re also not out of line for a utility.
That said, the interest coverage ratio would be closer to 4 if not for the tax hit to GAAP results last fiscal year.
Profitability is robust. PPL is producing numbers that compete with some of the best utilities.
Over the last five years, PPL Corp. has averaged annual net margin of 14.74% and annual return on equity of 11.77%.
This is a business model that easily passes Lynch’s test for simplicity. You don’t have to look far for someone using electricity.
Investors who like their dividends big, safe, and growing will almost surely like this stock.
PPL has had some challenges over the last decade, as have most businesses.
But they still kept pumping out and growing that dividend, which speaks volumes.
That should continue well into the future.
Their core service is necessary and ubiquitious, further protected by local monopolies.
The rate a utility can charge is backed by local government, which is further assisted by investment. This is a cash cow.
Meanwhile, there aren’t many risks to contend with here.
Growth is, of course, naturally limited by geography.
Government regulation ensures the rates, but it also means there’s a cap on growth.
A larger shift to cleaner energy is impossible to quantify right now, but it’s something to keep an eye on.
The company’s unique footprint has also been an issue of late.
That’s due to to the company’s exposure to the UK. Brexit, a weakening pound, and the potential of price capping in the UK are on investor’s minds.
But it’s important to note that PPL only provides transmission – not generation – in the UK.
A high-yielding utility is always a welcome sight for yield-hungry investors.
That’s especially true when the stock appears to be undervalued.
The stock looks really appealing after dropping more than 20% over the last year…
The P/E ratio is sitting at 12.30 right now.
I’m again using adjusted TTM EPS that factors out the one-time tax hit for Q4 2017.
That obviously compares quite favorably to the broader market. But it’s also well below the stock’s own five-year average P/E ratio of 15.4.
In addition, the price-to-cash flow ratio is sitting at 7.4 right now. This is almost 15% lower than the three-year average P/CF ratio of 8.7.
And the yield, as noted earlier, is substantially higher than its own recent historical average.
So the stock looks rather cheap here. But how cheap might it be? What would a rational estimate of fair 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%.
This is a cautious look at future dividend growth, based on all of the numbers we saw earlier.
I would expect something closer to 4% over the near term.
The DDM analysis gives me a fair value of $35.65.
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.
We can see that the basic valuation metrics indicated the stock is cheap. Multiples are low across the board. The DDM analysis further reinforces that viewpoint.
But we’ll now compare that valuation with where two professional stock analysis firms have come out at. This adds balance, depth, and perspective to our conclusion.
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.
We have a very strong consensus here. Averaging out the three numbers gives us a final valuation of $35.22. That would indicate the stock is potentially 12% undervalued right now.
Bottom line: PPL Corp. (PPL) provides a ubiquitous and necessary service to millions of customers. And they do it in a monopolistic way that should further ensure growing profit and dividends. The stock offers a 5%+ yield, almost two straight decades of dividend growth, and the potential that shares are 12% undervalued. Dividend growth investors should strongly consider this high-quality stock that passes one of Peter Lynch’s basic principles.
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 77. 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 with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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