The US stock market is one of the greatest wealth creators ever known to man.
Yet so many people don’t properly take advantage.
And this leaves them much poorer as a result.
Getting rich fast might be more myth than reality, but becoming relatively wealthy in a reasonable time frame is actually quite straightforward.
I’ll share with you one of the best paths toward that end…
A dividend growth stock represents equity in a company that is sharing its growing profit with shareholders in the form of increasing cash dividend payments.
Since a company can’t pay out ever-larger payments without doing a lot of things right, dividend growth stocks are often great long-term investments.
Hold these stocks for the long haul.
Collect and reinvest increasing dividend income along the way.
Rinse. Repeat. Enjoy.
This simple concept is what allowed me to go from below broke at 27 years old to financially independent and retired at 33.
I’m now a relatively wealthy guy, living out my early retirement dreams.
Make sure to read through my Early Retirement Blueprint to see exactly how that journey played out.
I bought a lot of high-quality dividend growth stocks that can be found on the Dividend Champions, Contenders, and Challengers list.
I purchased at appealing valuations, held them, and reinvested my dividends.
The outcome of that repetition is my FIRE Fund.
That’s a real-life and real-money portfolio.
And it generates the five-figure and growing passive dividend income I need to cover my essential expenses in life.
That’s because of human nature.
The best time to buy a great stock is precisely when people are most fearful.
Our emotions work against us sometimes.
A big price drop can create a great opportunity, yet that’s exactly when people want to back away.
Overcoming these emotions require understanding and recognizing value.
Price is what something costs; value is what something is worth.
You need to separate the two if you want to become a successful investor.
An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and reduced risk.
That’s relative to what the 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.
The higher yield goes on to lead to greater long-term total return potential, since total return is comprised of investment income and capital gain.
But the latter is given a possible boost, too, via the “upside” that’s possible when there’s a favorable gap between price and value.
A temporary mispricing can, and likely will, be corrected by the market over the long run, leading to capital gain.
And that’s on top of whatever capital gain is possible as a company increases its profit and becomes worth more, increasing its stock price over time.
This favorable gap between price and value should also reduce risk.
That’s because you introduce a margin of safety when price is well below value.
This limits the chances that you could end up “upside down” on your investment – where the stock is worth less than you paid.
A margin of safety is always imperative for the long-term investor.
Any number of adverse and unforeseen events can occur. Mismanagement. Increased competition. New regulations.
So on and so forth.
An investor must protect themselves by building in a margin of safety, buying a high-quality stock when its price appears to be well below intrinsic value.
Fellow contributor Dave Van Knapp has made the valuation process much easier for investors.
Part of an overarching series of “lessons” on dividend growth investing, Lesson 11: Valuation describes a process that can be roughly applied as a template to most dividend growth stocks.
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…
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, 63% of FY 2018 sales; Services, 14%; Mac, 10%; iPad, 7%; Other Products, 7%.
Net sales by operating segment breaks down as such: Americas, 42% of FY 2018 sales; Europe, 24%; China, 20%; Japan, 8%; Rest of Asia Pacific, 7%.
Apple is one of the world’s largest companies. The current market cap is almost $750 billion, although that’s a far way off from the $1 trillion market cap the company breached not long ago.
However, the stock has taken a beaten of late. And that’s why we’re talking about it today.
Due to the company’s decision to no longer break out iPhone volumes, concerns over tension in China, potential tariffs, and broader economic/market trends, the stock is down ~22% since early October 52-week highs.
But this is where we have to separate price from value. The company certainly hasn’t lost 22% of its profit over that time frame, nor is the company somehow 22% worse off than it was before.
The stock arguably got ahead of itself when it was over $230/share, but it now looks like a bargain after the rapid descent.
Let’s first talk about the company’s dividend.
Apple is quickly becoming one of the best dividend growth stocks in all of tech.
They’ve increased their dividend for seven consecutive years.
A short track record, yes. But they’re growing it at an astounding rate.
The five-year dividend growth rate is 26.6%.
With a payout ratio of 47.6%, the company has plenty of room for many more aggressive dividend raises.
That ability is bolstered by over $200 billion in cash and marketable securities on the balance sheet. Netting it out (after factoring in long-term debt), it’s still well over $100 billion.
Apple has already announced that they plan on running a net cash-neutral business going forward.
This implies plenty more large dividend increases, along with a lot of share buybacks.
Those buybacks, by the way, will help with dividend increases, since less shares outstanding gives more breathing room for dividend raises on the remaining shares.
That’s great news. The stock only yields 1.61% right now.
So that’s not a lot of current income, which means an investor has to count on a lot of that implied growth for the investment to make sense over the long haul.
Apple’s most recent dividend increase was over 16%. That’s just the start, in my view.
Those future dividend increases will rely, in part, on future business growth.
Estimating this growth will help us determine our expectation for dividend growth, which will in turn help with valuing the business as a whole.
That forward-looking estimation will be built on an incorporation of long-term past growth (which is known) and future growth (which is a professional forecast).
Apple increased its revenue from $42.905 billion in FY 2009 to $265.595 billion in FY 2018. That’s a compound annual growth rate of 22.45%.
This is a huge growth rate. It’s even more impressive when you consider the large base upon which that growth occurred.
Meanwhile, earnings per share advanced from $1.30 to $11.91 over this period, which is a CAGR of 27.90%.
Phenomenal. Almost beyond words, really.
The excess bottom-line growth was driven largely by buybacks.
The outstanding share count is down by approximately 21% over the last decade. That’s a rather large reduction in the share count for a company with a market cap that was recently over $1 trillion.
Moving forward, CFRA is predicting that Apple will compound its EPS at an annual rate of 10% over the next three years.
Continued buybacks, margin support via high-margin Services business, and Apple’s superior ecosystem support that double-digit growth thesis.
However, the company’s large size means this growth, while strong, would be far below what transpired over the last decade.
I think this is a realistic, if conservative, forecast.
Either way, it would easily support double-digit dividend growth moving forward, after factoring in the payout ratio and balance sheet.
That balance sheet sports a long-term debt/equity ratio of 0.87. But it’s somewhat moot since cash and marketable securities cover long-term debt more than twice over.
And the interest coverage ratio, at over 23, is extremely healthy as it sits.
Profitability is generally robust across some of the more dominant firms in tech, but Apple sports some particularly striking numbers.
Apple has averaged annual net margin of 21.83% over the last five years. They averaged annual return on equity of 40.60% over that period.
Net margin might not be expanding like it once was.
However, the fact that Apple is even able to maintain these huge margins in the face of stiff competition in the smartphone market speaks volumes.
Low-priced models coming in from Chinese manufacturers have been problematic on the volume side, but Apple has adeptly moved over to concentrating on their higher-margin Services business, which takes advantage of their unique ecosystem.
That ecosystem is really at the heart of what’s so great about Apple. They offer a unique experience in the marketplace. Consumers enjoy that value proposition, which is why the products command a healthy premium.
Smartphones are now ubiquitous. They’re practically as necessary to modern-day society as electricity or running water. That puts a floor under revenue. It’s recurring almost in the way it would be recurring for a utility.
When smartphones inevitably tire, break, or become outdated, upgrades (via new purchases) ensue.
Apple’s superior experience and ecosystem, aided by an intuitive GUI that relies on a seamless hardware-software integration, support their premium position in the marketplace.
And the company’s tilt toward Services should improve the sustainability of their business in the face of rising competition and changes in technology.
Risks, however, should be considered.
Technology can change fast. If Apple falls behind in any way, this could harm the brand.
Cheaper smartphones have flooded the global market, which leaves Apple’s products looking quite expensive by comparison.
And the company’s size and maturity means future growth will naturally be slower than past growth.
Overall, this is a very high-quality company. That’s one reason why Warren Buffett has been so aggressive over the last two or so years building up a position in Apple.
At the right price, this could be a fantastic long-term investment.
I believe the current valuation is giving investors that “right price”…
The stock trades for a P/E ratio of 15.19.
That’s well below the broader market. It’s also basically right in line with the stock’s own five-year average P/E ratio.
I think that’s better than it initially sounds.
I’m considering the broader market’s elevated valuation here. I think it’s also important to remember that Apple’s stock has been cheap over much of that five-year period.
So it’s a stock that’s been cheap. And it remains relatively cheap.
Most other basic valuation metrics are more or less in line with their recent historical averages. But the thesis just noted above translates over to all of the other metrics.
If the stock is cheap, how cheap might it be? What would a reasonable look at fair value look like?
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 17%, and a long-term dividend growth rate of 7%.
But I don’t think that’s the case here.
Apple’s EPS growth alone supports double-digit dividend growth.
That’s before considering the balance sheet ammunition, which is substantial.
The company’s net cash, for example, exceeds the market cap of most Fortune 500 companies.
Moreover, the most recent dividend increase was right in line with that estimation.
But I do think it will flatten out over time.
The flattening occurs after a 10-year process of reducing the balance sheet.
The DDM analysis gives me a fair value of $234.65.
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.
I don’t believe my analysis was reckless. If anything, the flattening out was overly conservative. Yet the stock looks very cheap here based on this.
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 AAPL as a 3-star stock, with a fair value estimate of $200.00.
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 12-month target price of $255.00.
I came out almost in the middle here. Averaging out these three numbers gives us a final valuation of $229.88. That would indicate the stock appears to be 27% undervalued right now.
Bottom line: Apple Inc. (AAPL) is one of the largest and most dominant companies on the planet. Their premium products, unique ecosystem, and seamless user experience are unrivaled. Fantastic fundamentals, a recent 16%+ dividend increase, almost $100 billion in net cash, and the potential that shares are 27% undervalued means dividend growth investors should perhaps join Warren Buffett and buy this stock.
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 95. 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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