I remember a popular slogan from my childhood.
“Be like Mike”.
It was an advertising campaign built around Michael Jordan.
Well, I never was any good at basketball.
That’s why I’ve decided to “be like” someone else incredibly successful and wealthy.
I’m talking about Warren Buffett.
I try to “be like Buffett”.
Buffett is arguably the most successful investor to ever live.
Through Berkshire Hathaway Inc. (BRK.B), he controls a $200+ billion common stock portfolio.
You know what you’ll find in that portfolio?
Numerous high-quality dividend growth stocks.
Stocks you can find on the Dividend Champions, Contenders, and Challengers list.
To be like Buffett is to be a dividend growth investor.
By being like Buffett, I built my own real-money dividend growth stock portfolio.
My FIRE Fund.
And it generates enough five-figure passive dividend income for me to live off of.
Being like Buffett allowed me to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
Of course, Buffett doesn’t just buy high-quality dividend growth stocks.
He buys them for the long term.
While price is what you pay, value is what you get.
Valuation at the time of investment can play a critical role in the long-term success of an investment.
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.
This higher yield leads to greater long-term total return potential.
Total return is, after all, the sum of investment income and capital gain.
Boosting yield gives you more potential investment income.
Capital gain gets a potential boost, too, via the “upside” between a lower price and higher intrinsic value.
Putting the two together is a massive boon for your possible long-term rate of return.
All of this should also reduce risk.
Undervaluation introduces a margin of safety.
That’s a “buffer” that protects an investor’s downside against unforeseen issues.
You want to limit your downside, while simultaneously maximizing your upside.
These dynamics are clearly favorable to the long-term investor.
Fortunately, they’re not that difficult to spot and take advantage of.
Fellow contributor Dave Van Knapp put together an excellent template designed to ease the process of stock valuation.
Part of a series of “lessons” on dividend growth investing, Lesson 11: Valuation provides fantastic information on valuation.
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…
Wells Fargo & Co. (WFC)
Wells Fargo & Co. (WFC) is one of the four largest banks in the US, with diversified financial offerings across retail, commercial, and corporate banking services.
Founded in 1852, Wells Fargo has grown to ~$1.9 trillion in assets and 70+ million customers. They’re now one of the largest financial institutions in the world.
The company reports results across three segments: Community Banking, 54% of FY 2018 revenue; Wholesale Banking, 33%; and Wealth and Investment Management, 19%. Other accounted for -6%.
The bank is #1 in retail deposits, with $1.3 trillion in average deposits in 2Q19.
Their loan portfolio is 54% commercial and 46% consumer.
Want to be like Buffett?
Then invest in high-quality banks at attractive valuations. It’s as simple as that.
Buffett has been heavy into large banks, including Wells Fargo, for decades now. Berkshire’s Wells Fargo investment dates back to 1990.
Wells Fargo is one of Berkshire’s largest common stock positions.
It doesn’t take a genius to figure out why.
Big banks are cash machines.
Wells Fargo has access to an extremely large amount of very low-cost capital through its deposits. That supercharges everything else they do, including the lending.
Buffett has long been a big fan of businesses with floats.
A “float” is a source of capital that can be accrued as a natural course of doing business.
In the case of a bank, it’s the money that builds up in the form of deposits. This capital comes with very little risk and cost, yet it can earn much more for the bank and its shareholders when it’s put to work.
That means profit.
Dividend Growth, Growth Rate, Payout Ratio and Yield
It also means dividends.
Being like Buffett means collecting growing dividends.
Well, Wells Fargo is paying a sizable and growing dividend.
They’ve increased their dividend for nine consecutive years.
The one knock against this track record is that Wells Fargo, like many other financial institutions, cut its dividend during the financial crisis.
However, that was a very rare type of financial event that is unlikely to repeat itself.
The five-year dividend growth rate stands at 7.4%.
That might seem a bit low, and maybe it is, but that’s because the Federal Reserve has been tightly monitoring and regulating banks since the financial crisis.
The middling dividend growth is not because Wells Fargo is unable to do more.
However – this is great news for shareholders – Wells Fargo recently passed another round of “stress tests” with flying colors – and they increased their dividend by over 13%.
I think there’s plenty more where that came from.
The payout ratio is only 42.1%, so this is a well-covered dividend.
Meanwhile, the stock yields a monstrous 4.18% right now.
Even if Wells Fargo only hands out high-single-digit dividend raises from here, you’re getting that on top of a 4%+ yield.
That yield, by the way, is more than twice what the broader market offers.
It’s also ~140 basis points higher than the stock’s own five-year average yield.
A lot to like about the dividend, that’s for sure.
But let’s see where the bank and its dividend might be going as we move forward.
After all, we invest in the future of a company. We invest in where a business is going, not where it’s been.
Revenue and Earnings Growth
I’ll build a forward-looking growth trajectory by first looking at what Wells Fargo 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.
Blending the known past and estimated future in this manner should give us plenty to work with.
Wells Fargo’s revenue is fairly flat over the decade – moving from $88.501 billion in FY 2009 to $86.408 billion in FY 2018.
This wouldn’t be the only bank that has found it tough to grow sales over the last 10 years.
Suffice to say, it’s been a challenging period.
Low interest rates, an anemic economic recovery out of the Great Recession, and the overall size of Wells Fargo have all worked against the bank.
But Wells Fargo made it more difficult than it should have been by shooting themselves in the foot with a fake accounts scandal that revealed incorrect compensation incentives that promoted the idea of opening fake customer accounts.
This damage to the bank’s reputation has kept a lid on the bank’s growth and the stock’s price over the last few years.
Wells Fargo has made steady moves to right the ship and regain customer trust.
The good news is that bank assets tend to be very sticky, which stems the outflow of capital.
And, perhaps a silver lining, Wells Fargo has been buying back stock hand over fist over the last few years. These buybacks have almost certainly been occurring at lower prices than they otherwise would have been, had the scandal not broke.
This has had the effect of juicing the bank’s growth in profit on a per-share basis.
Earnings per share increased from $1.75 to $4.28 over this same 10-year period, which is a compound annual growth rate of 10.45%.
Now you see what I mean.
The bank’s revenue has basically gone nowhere over the last 10 years.
But profitability improvements combined with substantial buybacks have left us with a business that is growing EPS very nicely.
And Wells Fargo continues to buy back a ton of stock. So much stock, in fact, that Warren Buffett has been forced in recent years to sell down some of Berkshire’s position in the bank in order to not cross over an unwanted 10% ownership threshold (which would trigger certain additional regulations for Berkshire).
For context, Wells Fargo’s most recent buyback plan came in at over $23 billion. That’s more than 10% of the company’s market cap.
Looking forward, CFRA is anticipating that Wells Fargo will compound its EPS at an annual rate of 5% over the next three years.
I think this is a reasonable expectation.
If we isolate more recent EPS growth from Wells Fargo, it’s been more lumpy and slower than it was coming out of the Great Recession.
CFRA notes the bank’s scale, buybacks, and position in the marketplace, but Federal Reserve scrutiny and the reputation damage are major headwinds.
Adding to the bank’s challenges is the interest rate environment we find ourselves in.
Instead of rates rising throughout 2019, as many had anticipated only just a year ago, interest rates are now falling. This squeezes a bank’s possible net interest income.
Still, a 5% CAGR in the bank’s EPS would allow for at least dividend growth in that same range.
With the payout ratio being where it’s at, dividend growth could even modestly outpace EPS growth over the foreseeable future.
Moving over to the balance sheet, Wells Fargo has long prided itself on a rock-solid financial position.
It’s no different today.
The long-term debt/equity ratio is 1.17, which is in line with other large US banks.
Senior debt is rated as a A- from S&P and a A2 from Moody’s.
Over the last five years, the bank has averaged annual return on assets of 1.17% and annual return on equity of 12.29%. Net interest margin came in at 2.91% for FY 2018.
This level of profitability is highly competitive, and these metrics have all improved relative to where things were at in the prior five-year period.
Wells Fargo hasn’t been without its challenges.
But the bank is still a massive financial institution that is arguably operating about as well as it ever has.
Investing in Wells Fargo is “being like Buffett”.
Of course, there are risks.
Regulation, litigation, and competition are omnipresent risks in every industry.
The falling interest rate environment in the US is an additional concern, as this constrains the bank’s ability to earn a profit.
Any kind of recession, particularly in the United States, would directly impact Wells Fargo.
The bank’s size does work against it, and its reputation still has a long way to go before customer trust is fully healed.
Lastly, the company’s large retail branch footprint could be a liability in the future as banking increasingly moves online.
Overall, there’s really a lot to like about Wells Fargo.
Stock Price Valuation
But what makes it particularly compelling right now is the valuation…
The stock’s P/E ratio is a lowly 10.08.
That’s practically a single-digit P/E ratio.
This is almost half that of the broader market’s earnings multiple, and it’s markedly below the stock’s own five-year average P/E ratio of 13.1.
The P/B ratio is coming in at 1.2, which is quite a way’s off of the five-year average P/B ratio of 1.6.
And the stock’s yield, as noted earlier, is significantly higher than its own recent historical average.
So the stock does look cheap. But how cheap might it be? What would a reasonable estimate of intrinsic value look like?
I valued shares using a dividend discount model analysis.
I factored in a 9% discount rate (due to the elevated yield) and a long-term dividend growth rate of 5.5%.
That DGR is very conservative.
It’s obviously much lower than the bank’s own DGR over the last decade. Even the most recent dividend increase was more than twice as high as this.
But I think it’s a good time to err on the side of caution for a bank like this.
Interest rates are falling. Plus, the near-term forecast for EPS growth is in this range.
I think the bank is positioned to actually do better than this over the long run.
But if they don’t, this valuation is anticipating such an event.
The DDM analysis gives me a fair value of $61.49.
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 believe my valuation was reasonable, if not abundantly cautious, yet the stock still looks pretty cheap.
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 WFC as a 4-star stock, with a fair value estimate of $58.00.
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 WFC as a 3-star “HOLD”, with a 12-month target price of $50.00.
A bit of a range, but I came out pretty close to where Morningstar is at. Averaging out the three numbers gives us a final valuation of $56.50, which would indicate the stock is possibly 16% undervalued.
Bottom line: Wells Fargo & Co. (WFC) is a massive and highly-profitable financial institution with sticky assets that provide it an enviable float. This is one of Warren Buffett’s largest investments. With a 4%+ yield, almost a decade of dividend raises, a recent double-digit dividend increase, a low payout ratio, and the potential that shares are 16% undervalued, investors may want to “be like Buffett” and consider buying this stock.
Note from DTA: How safe is WFC’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 79. 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, WFC’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
Avoid These Kinds of 5G Stocks Like the Plague [sponsor]
The 5G communication build-out is going to be the biggest, most important, most lucrative new “highway” built in our lifetimes. Yet most people are investing in it the WRONG way. Legendary stock picker Matt McCall reveals details about the best 5G stocks to buy now. Click here to learn more.