It’s called the “stock market”.
But it’s really a market of stocks.
Every stock represents fractional ownership of a real business.
With that comes unique dynamics in every case.
One of those dynamics, of course, is valuation.
The broader stock market is sitting at all-time highs.
While that means many individual stocks are also at all-time highs, that’s not the case for all stocks.
And that’s where the opportunities could lie.
I spent six years of my life scooping up these opportunities.
I bought high-quality dividend growth stocks when they were undervalued.
Then I sat on them, reinvested my growing dividend income, and waited.
My FIRE Fund, which is my real-money early retirement stock portfolio.
This fund generates six-figure dividend income.
That passive income allowed me to retire in my early 30s.
I lay out exactly how I accomplished such a feat in my Early Retirement Blueprint.
Indeed, I’ve always stuck to high-quality stocks that pay growing dividends.
Stocks like those you’ll find on the Dividend Champions, Contenders, and Challengers list.
The reasoning is quite simple.
And since publicly traded companies are collectively owned by shareholders, a portion of that growing profit should come right back to the owners.
In addition, growing cash dividend payments can be the ultimate form of passive income.
You can use this growing passive dividend income to retire early, live off of, and create a life of your dreams.
But valuation is important.
Price is what something costs. But value is what it’s worth.
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 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.
This higher yield leads to greater long-term total return potential.
Total return is comprised of investment income and capital gain.
The higher yield gives investment income, and thus total return, a boost right off the bat.
However, capital gain is also given a possible boost.
That’s due to the “upside” available between price and value.
The stock market doesn’t always accurately price stocks in the short term.
Over the long haul, though, price and value tend to correlate more closely.
Buying when there’s a temporary dislocation leads to that upside.
Undervaluation should also reduce risk.
It introduces a margin of safety. A “buffer” that protects an investor’s downside against unforeseen issues that can lower the value of a business.
Think new regulation, additional competition, mismanagement.
Anything can happen.
An investor should always be cautious and seek a margin of safety.
Undervaluation is obviously appealing. The dynamics are highly favorable.
Fortunately, it’s not impossible to spot and take advantage of undervaluation.
Fellow contributor Dave Van Knapp has made that easier for investors via the introduction of his “lesson” on valuation.
Part of an overarching series on the dividend growth investing strategy, Lesson 11: Valuation is a fantastic tutorial on why valuation matters and how to value 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…
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 2018 revenue; UK Regulated, 29%; Pennsylvania Regulated, 29%.
The company provides necessary energy services to more than 10 million customers in both the US and the UK.
A utility like PPL Corp. is a very simple business model. And that’s part of the beauty.
Energy is a ubiquitious and necessary component to modern-day society.
Billions of people rely on power every single day.
Of course, there’s lots of money to be made in that.
Companies that provide reliable and cost-effective energy are basically guaranteed by governments to earn a certain profit.
Dividend Growth, Growth Rate, Payout Ratio and Yield
PPL Corp. and its shareholders are witnessing that firsthand.
The company has paid an increasing dividend for 18 consecutive years.
Now, utilities aren’t fast-growing tech companies. Not even close.
But they typically offer big, safe dividends that grow slightly in excess of inflation.
And that’s more than enough for many investors.
We can see that play out here.
The stock offers a yield of 5.36% right now, which is extremely high in this environment.
This yield is more than 50 basis points higher than the stock’s five-year average yield.
That’s offset a bit by lower dividend growth – the ten-year dividend growth rate is only 2.7%.
Inflation is low. That DGR is enough to outpace inflation.
But the relationship between yield and growth is something to be aware of.
Still, if you’re looking for healthy income in today’s low-rate world, this stock should be on your radar.
With a payout ratio of 64.0%, there’s also room for modest dividend growth moving forward.
In fact, management has been guiding for 4% dividend growth through 2020, backed by 5%-6% earnings growth over the same period.
Assuming a static valuation, the sum of yield and dividend growth should equal total return.
A 5%+ yield and ~4% dividend growth is thus awfully appealing in an expensive market, especially knowing that most of that equation favors cash in your pocket right now.
But in order to determine whether or not this dividend growth expectation is realistic, let’s look at what kind of revenue and earnings growth PPL Corp. is producing.
Revenue and Earnings Growth
I’ll first show you what the utility has done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional forecast for profit growth.
Combining the proven past with the forecasted future should give us the information we need to estimate the company’s earnings power and dividend growth potential moving forward.
PPL Corp. grew its revenue from $7.556 billion to $7.785 billion from FY 2009 to FY 2018. That’s a compound annual growth rate of 0.33%.
Meanwhile, earnings per share increased from $1.08 to $2.58 over this period, which is a CAGR of 10.16%.
Growth has been lumpy, so it depends on the comparative time frame.
More recent bottom-line growth has been in the low single digits. And that’s right about what one should expect from a utility like this.
CFRA is predicting that PPL Corp. will compound its EPS at an annual rate of 5% over the next three years.
That’s on the low end of recent management guidance, which seems fair.
CFRA does note customer growth and rate increases as opportunities.
One potential issue that reduces clarity regarding growth is the UK regulatory framework.
There has been clamor that UK regulators might come down on electricity distribution rates, following recent unfavorable rhetoric targeting gas and transmission utilities.
Beyond that, there remains a lot of questions regarding Brexit and currency.
Other than the uncertainty, though, I don’t see much of a problem in current reality. The numbers are very good.
The utility has more exposure to more favorable and stable US markets. And PPL Corp. remains, thus far, on track to deliver on its goals.
Moving over to the balance sheet, it’s unsurprisingly levered.
Utilities are typically highly leveraged due to the asset-heavy business that is capital intensive.
On the other hand, stable cash flows provide a balance against that dynamic.
The long-term debt/equity ratio is 1.72, while the interest coverage ratio is just over 3.
These numbers are more than acceptable for a large utility. I don’t see anything noteworthy here.
Profitability, however, is slightly noteworthy in the sense that it’s robust and competitive with some of the best utilities out there, even after factoring out the lumpiness.
Over the last five years, PPL Corp. has averaged annual net margin of 17.54% and annual return on equity of 13.07%.
We’re talking about a very simple investment thesis here.
It’s a simple business model that provides a ubiquitious and necessary service to millions of people. This company is almost guaranteed to make money.
As such, investors are practically guaranteed to collect a dividend. An attractive dividend that’s growing, no less.
But there are risks.
Competition, regulation, and litigation are omnipresent risks for all companies.
However, utilities scale down competition (due to local monopolies) and scale up regulation (due to heavy government oversight) relative to most other businesses.
I touched on the more pertinent risks earlier, which relate to this company’s rather unique geographic footprint.
Beyond that, there is sensitivity to interest rates.
Rising rates would make their debt load more expensive while simultaneously making the stock’s yield less attractive on a relative basis.
Overall, though, this is an appealing long-term investment for dividend growth stocks.
But it’s especially appealing right now due to the valuation…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 12.12.
That’s obviously well below the broader market, which is over 20.
Moreover, this multiple is below both the industry average and the stock’s own five-year average P/E ratio of 16.0.
Admittedly, it’s sometimes difficult to get a read on a utility’s valuation with a P/E ratio because of frequent hits to GAAP earnings.
However, going straight to cash flow reveals a P/CF ratio of 7.8, which is also below the industry average and the stock’s own three-year average P/CF ratio of 8.8.
And the yield, as noted earlier, is significantly higher than its recent historical average.
So the stock does look cheap. But how cheap? What would a reasonable 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 DGR is pretty conservative when you compare it to long-term EPS growth and the expectation for EPS growth moving forward.
It’s also below management’s guidance for near-term dividend growth.
The DDM analysis gives me a fair value of $35.87.
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.
A lot of utility stocks are expensive right now, but this one appears to be downright cheap.
The DDM analysis jibes with the basic valuation metrics.
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 3-star stock, with a fair value estimate of $31.00.
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.
I came in right where CFRA did. Averaging out the three numbers gives us a final valuation of $33.96. That would indicate the stock is possibly 9% undervalued.
Bottom line: PPL Corp. (PPL) runs a very simple business model that provides a necessary and ubiquitous service to millions of people. With a 5%+ yield, a reasonable payout ratio, almost 20 consecutive years of dividend raises, and the potential that shares are 9% undervalued, this is a rare high-yield dividend growth stock that looks undervalued in this market.
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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 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, PPL’s dividend appears safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.