Undervalued Dividend Growth Stock of the Week: Walt Disney Co. (DIS)

Warren Buffett has often talked about an “economic moat”.

Think of a company as a castle.

Well, the moat is what keeps the invaders (competition) out.

The more competitive advantages a company has, the wider that moat is.

Investing in companies with wide economic moats can protect capital and lead to outstanding returns over time.

Indeed, investing in companies with durable competitive advantages and wide economic moats helped me retire in my early 30s.

I went from below broke at 27 years old to financially free at 33.

I lay out how that process occurred in my Early Retirement Blueprint.

A major aspect of my plan involved a particular investment strategy.

That strategy is dividend growth investing.

By investing in high-quality dividend growth stocks, I accomplished two big things.

First, I was mostly sticking to companies with wide economic moats. 

That’s because it’s almost impossible to pay out rising cash dividend payments to shareholders for years on end without running a high-quality company that has competitive advantages.

Second, I was able to build a sustainable and growing source of totally passive income that could pay my bills.

Investing in this way has resulted in the FIRE Fund.

That’s my real-life and real-money portfolio.

And it generates the five-figure and growing passive dividend income I need to live out my early retirement dreams.

Check out the Dividend Champions, Contenders, and Challengers list for more than 800 US-listed stocks that have all raised their dividends each year for at least the last five consecutive years.

Jason Fieber's Dividend Growth PortfolioIt should be no surprise that many of those companies have durable competitive advantages and wide economic moats.

After all, you can’t run a great business and pay out rising dividends if competition is storming your castle and running through your halls.

That said, it’s more than just competitive advantages, which generally results in great fundamentals.

Valuation is also very important.

This is another subject that Warren Buffett has talked about time and again.

While price is what something costs, value is what something is worth. The former is what you pay, the latter is what you get.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return prospects, and reduced risk.

This is all relative to what the same stock might otherwise offer if it were instead fairly valued or overvalued.

All else equal, a lower price will result in a higher yield.

Price and yield are inversely correlated.

A higher yield then leads to greater long-term total return prospects.

That’s because total return is simply made up of two components: capital gain and investment income.

The possible investment income is boosted by the higher yield.

Capital gain is also given a possible boost, however, by the “upside” between price and intrinsic value.

If price is temporarily below the estimate of fair value, that sets an investor up for capital gain that would come about as a stock eventually becomes more appropriately priced.

And that’s on top of whatever capital gain would play out as a company naturally becomes worth more over time.

These dynamics should also reduce risk.

That’s because undervaluation introduces a margin of safety.

This is a buffer that protects the investor’s downside against unforeseen events that can erode value.

Since value is always an estimate, we need to be as cautious as possible when valuing and buying stocks.

The lower the price we can pay, the less likely we are to be caught by surprise and see our investments go sour.

Fortunately, spotting undervalued dividend growth stocks is far from an impossible task.

Fellow contributor Dave Van Knapp has made that process even easier.

His Lesson 11: Valuation, part of a series of “lessons” on DGI, lays out a valuation template that can be applied to almost any dividend growth stock out there.

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…

Walt Disney Co. (DIS)

Walt Disney Co. (DIS), together with its subsidiaries, operates as a global diversified media and entertainment conglomerate.

Founded in 1923, Walt Disney Co. now operates with more than 200,000 employees across more than 40 countries.

They operate across the following segments: Media Networks, 41% of FY 2018 revenue; Parks and Resorts, 34%; Studio Entertainment, 17%; and Consumer Products & Interactive Media, 8%.

When I think of wide economic moats, Walt Disney Co. is one of the very first companies I think of.

There’s no other media and entertainment company quite like it.

The sheer breadth, depth, and diversification of its various businesses is unrivaled. And the way the company is able to cross-promote across its platforms is unique and incredible.

Let’s break some of that down quickly.

That Media Networks segment includes one of the “big four” domestic broadcasting networks: ABC. It also includes various affiliate networks and numerous cable properties. The venerable ESPN is the “crown jewel” there.

If that’s all Walt Disney Co. were, it’d be a mighty media company.

But it’s just scratching the surface.

There are also the worldwide theme parks. Think everything from Walt Disney World Resort in Orlando, Florida to Shanghai Disney Resort (of which they own 43%) in Shanghai, China.

Then there’s the Studio Entertainment business.

A dominant force in studio content, Walt Disney Co. produces incredibly popular films across their various properties from LucasFilm, The Walt Disney Studios, Marvel Studios, and Pixar.

Some more recent hit movies include Star Wars: The Last Jedi, Frozen, Avengers: Infinity Wars, and Black Panther.

These movies make a ton of money at the global box office. Every movie I just listed did over a billion in worldwide ticket sales. The company routinely produces billion-dollar franchises.

These aren’t just movies, however.

Walt Disney Co. makes entire worlds out of these films, using them as platforms to cross-promote within their broadcasting, parks, and even toy lines.

For example, there’s the new Star Wars: Galaxy’s Edge at Disneyland Resort. That’s a themed attraction that gives life to the entire Star Wars world, feeding back into itself.

The company is an incredible marketing and money machine that’s set to get even bigger, better, and broader with the pending acquisition of certain entertainment assets of Twenty-First Century Fox Inc. (FOX.A) for just over $71 billion.

This significantly increases Walt Disney Co.’s library of content, as well as their distribution capabilities.

Knowing what we know about this company, it means there are entire cross-promotional worlds to build with older and newer characters alike.

The acquisition will be a huge boost to what’s already a clear leader in studio productions, which Walt Disney Co. believes will only serve to bolster their efforts to build a major direct-to-consumer content business.

This new DTC, over-the-top business will compete with the likes of Netflix, Inc. (NFLX) and give Walt Disney Co. even more control over its content and destiny.

This should allow them to continue paying growing dividends to shareholders for many years to come.

As it sits, the company has increased its dividend for nine consecutive years.

The five-year dividend growth rate is a stout 17.5%.

With a low payout ratio of 24.1%, this dividend is about as secure as it gets.

The only drawback to the dividend might be the yield.

At only 1.53%, the stock doesn’t offer a lot of current income.

But I think that’s more than made up for by the sustainability and growth.

As part of a larger and diversified portfolio that has some higher-yielding, lower-growth picks, this stock could be a huge long-term winner in terms of total return and dividend growth.

But in order to estimate that future dividend growth, which will later help us value the stock, we’ll look at the earnings power of the company.

A dividend tends to grow in line with earnings over the long haul. And a stock price will generally move up (or down) with earnings over the long term, too.

The stock market can be awfully capricious, especially over short periods of time.

But it all comes down to earnings over the long term.

I’ll first show you what Disney has done over the last decade in terms of top-line and bottom-line growth, using that time period as a proxy for the long term.

Then I’ll reveal a professional near-term forecast for EPS growth.

Combining these numbers should give us a nice trajectory to work with.

Walt Disney Co. has grown revenue from $36.149 billion in FY 2009 to $59.434 billion in FY 2018. That’s a compound annual growth rate of 5.68%.

A very solid top-line rate of growth from a fairly mature media company.

Of course, this company is a master acquirer. Two major acquisitions occurred over this time period, which positively affected revenue. They were the acquisitions of Marvel Entertainment in 2009 for $4.24 billion, and LucasFilm in 2012 for $4 billion.

The amazing thing here is that, even with these acquisitions, the share count has gone down and the balance sheet has improved over this stretch.

Often, a company would see dilution and/or a stressed balance sheet with a series of fairly large acquisitions, but Walt Disney Co. got fantastic deals on perfect properties.

As such, the bottom line has fared even better than the top line.

Earnings per share improved from $1.76 to $7.08 (adjusted) over that 10-year time frame, which is a CAGR of 16.73%.

A phenomenal rate of growth. It’s now clear how they’ve been able to grow the dividend so aggressively while simultaneously maintaining a low payout ratio.

I even adjusted down FY 2018 EPS in order to factor out the tax gain for the year. This is adjusted EPS.

Share buybacks definitely helped, with Disney reducing outstanding share count by approximately 19% over this period.

Looking forward, CFRA is predicting that Walt Disney Co. will compound its EPS at an annual rate of 10% over the next three years.

While that’s a strong number, it would be off of what they’ve historically been able to do.

But I see the company in a state of flux right now. That makes the forecast difficult.

Primarily, there’s the massive aforementioned acquisition of certain entertainment assets of Twenty-First Century Fox Inc.

Walt Disney Co. has been a great acquirer in recent times, especially under current CEO Bob Iger, but this acquisition is substantially larger than either Marvel Entertainment or LucasFilm was.

And then there’s the move into the DTC business.

Walt Disney Co. arguably has the best library of content out there. Building that DTC/OTT business around ESPN and the various Disney properties is about as good as it can get if you’re starting from scratch. It positions them well in a competitive DTC arena. But there’s plenty of uncertainty here.

Still, even if they only grow at 10%, the low payout ratio easily sets shareholders up for low-double-digit dividend growth for the foreseeable future. It’s only a matter of how aggressive the company wants to be in that department.

The balance sheet is currently great. However, the numbers as they’re presented now will change if the Fox acquisition goes through, since Disney is paying in both cash and shares.

The long-term debt/equity ratio is 0.35, and the interest coverage ratio is over 22.

Debt and equity will go up if the acquisition is closed. The accretive nature of the move is what could move the dial in a big way, though.

According to Walt Disney Co., they should be able to yield $2 billion in cost synergies by 2021. The company expects the acquisition to be accretive in the second fiscal year after the close.

Profitability is, as expected, robust.

Over the last five years, the firm has averaged annual net margin of 17.14% and annual return on equity of 21.18%.

High-quality numbers for a high-quality firm.

Again, it’s hard to think of a company with a wider economic moat than Walt Disney Co.

They have the brands, scale, properties, and unrivaled ability to market its characters across its various platforms.

Each platform adds value to another. These are strong competitive advantages.

And if – it’s a big if – they’re successful with a new DTC/OTT business, they’ll have more control over content and marketing than ever before, along with a whole new platform to cross-promote on.

There are risks, of course.

Regulation and competition are omnipresent risks for any company.

The company is also sensitive to economic softness.

Any large recession would likely cause a drop in traffic to their capital-intensive theme parks. People still consume media in recessions, but going to the movies is a discretionary purchase.

However, I see the biggest risk as the integration of the entertainment assets from Twenty-First Century Fox Inc., which includes the rolling out of their DTC business.

Walt Disney Co. is attempting to adapt to changing media trends. But big ships take a while to turn.

The good news is that I believe the valuation prices in these risks, and more.

I think the stock is attractively valued here…

Shares trade hands for a P/E ratio of 15.52.

That’s way off of the stock’s own five-year average P/E ratio of 19.2. It’s also far below the broader market’s P/E ratio.

Every basic valuation metric I look at is below its respective recent historical average.

For example, the P/CF ratio, at 12.0, is notably lower than the stock’s three-year average P/CF ratio of 13.2.

So the stock looks cheap. But how cheap might it be? What would a rational look at intrinsic value look like?

I valued shares using a two-stage dividend discount model analysis (to account for the low yield/high growth dynamic).

I factored in a 10% discount rate.

The initial dividend growth rate I assumed, for the first ten years, is 12%.

I then assumed a long-term dividend growth rate of 8%.

This is a reasonable long-term growth expectation, in my view.

The long-term EPS and dividend growth rates that Walt Disney Co. has already produced are far higher than what I’m factoring in here.

With a low payout ratio and a near-term EPS growth forecast of low double digits, this is a thesis that’s easily supported by the numbers.

But more recent dividend raises have been modest by comparison.

And the integration risk is something to be cautious over, which is why I’m assuming numbers that are much lower than what the company has delivered over the long run.

The DDM analysis gives me a fair value of $133.26.

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.

The stock doesn’t look crazy cheap here.

However, it’s arguably one of the highest-quality companies in the world, with a very wide economic moat. And it looks to be trading for prices below what it’s conservatively worth, in an expensive market.

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 DIS as a 4-star stock, with a fair value estimate of $130.00.

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 DIS as a 5-star “STRONG BUY”, with a 12-month target price of $130.00.

A tight consensus here. Averaging the three numbers out gives us a final valuation of $131.09. That would indicate the stock is potentially 16% undervalued right now.

Bottom line: Walt Disney Co. (DIS) is a dominant and unique company that could have one of the widest economic moats in the world. A transformative acquisition, excellent fundamentals, almost a decade straight of dividend raises, a dividend that’s growing by double digits, a very low payout ratio, and the potential that shares are 16% undervalued are all reasons why dividend growth investors should seriously consider buying and owning this high-quality dividend growth stock for the long term.

-Jason Fieber

Note from DTA: How safe is DIS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 99. 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, DIS’s dividend appears very safe with an extremely unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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