The Dow Jones Industrial Average recently broke through 28,000 points for the first time ever.
Investors who bought in a while ago are probably pretty happy.
The stock market’s long-term wealth creation power is showing no signs of abatement.
However, this has left newer investors in a tough spot.
Finding value in this market is difficult.
One simply has to be vigilant.
Vigilance is something I’ve adopted and recommended since I started investing in early 2010.
I came upon an important realization back when I first started.
Buying and holding high-quality dividend growth stocks at attractive valuations can allow one to become incredibly wealthy in a relatively short period of time.
Dividend growth stocks take the incredible wealth-building power of equities and supercharge it with growing cash dividend payments.
As one might expect, many high-quality dividend growth stocks are world-class enterprises that sell the products and/or services which make the world work.
See what I mean by taking a look at the Dividend Champions, Contenders, and Challengers list.
This important realization would mean nothing without acting upon it.
So I put this realization into practice.
I bought and held high-quality dividend growth stocks at attractive valuations, building the FIRE Fund in the process.
That real-money portfolio generates the five-figure passive dividend income I live off of.
Being vigilant led me to being observant enough to pick up these stocks at good valuations, in all prevailing market conditions.
And it allowed me to go from below broke at 27 years old to financially free and retired at 33, as I lay out in my Early Retirement Blueprint.
Price is what you pay, but value is what you get for your money.
An undervalued dividend growth stock should provide a higher yield, greater long-term total return potential, and reduced risk.
This is relative to what the same stock might otherwise provide 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.
That higher yield correlates to greater long-term total return potential.
This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.
Prospective investment income is boosted by the higher yield.
But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.
And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.
These dynamics should reduce risk.
Undervaluation introduces a margin of safety.
This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value. It’s protection against the possible downside.
It’s fairly clear that being vigilant and seeking undervaluation is beneficial to the investor.
Fortunately, that is not difficult to do.
Fellow contributor Dave Van Knapp has made it easier than ever with Lesson 11: Valuation.
Part of an overarching series of “lessons” on DGI, Lesson 11 provides a fantastic valuation template that can be applied to just about 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…
KeyCorp (KEY) is a bank holding company that, through its subsidiaries, provides a range of retail and commercial financial services.
Headquartered in Cleveland, Ohio, KeyCorp operates more than 1,100 branches across 16 different US states. Their primary markets are Ohio and New York.
This regional bank still operates mainly as a old-school community bank, providing a number of local financial functions that include deposits, lending, and financial management.
FY 2018 revenue broke down across the following two segments: Key Community Bank, 64%; Key Corporate Bank, 36%.
A bank, at its core, is one of the most compelling business models out there.
This is largely due to the “float”, which is low-cost capital that builds up from the natural course of doing business.
The ability to build a float and earn a low-risk return from the spread between what you pay and what you earn on other people’s capital is easy money.
Furthermore, this allows a bank to build a great foundation from which to build out a range of other high-profit financial services.
That said, pervasively low interest rates have negatively impacted the bottom line of banks. And interest rates have continued to drop from already low levels.
There’s not much of a spread to take advantage of. In addition, low-risk returns on capital are limited.
The power of the float is diminished in this kind of environment.
Let’s not lose perspective, though.
Major US banks remain extremely profitable, even if they’re not as profitable as they could be.
And the monetary stimulus coming via the cuts in interest rates are designed to stimulate the economy and stave off a recession, which obviously works to the advantage of banks.
Moreover, a diversified bank always has a number of levers to pull – differentiation, building relationships, delivering value, making use of local expertise – in order to pump out strong growth and ever-growing dividends.
KeyCorp is doing all of this.
And shareholders are collecting their growing dividends as a result.
The bank has increased its dividend for nine consecutive years.
That’s a solid track record coming out of the Great Recession, which saw many banks (including KeyCorp) cut their dividends in the face of one of the worst financial crises we’ve ever seen.
With a five-year dividend growth rate of 21.3%, KeyCorp is making up for lost time here.
Admittedly, much of that dividend growth was due to an artificially low payout after the dividend cut, so it’s not the kind of growth rate you should count on over the long term.
However, the most recent dividend increase, which was announced in July, was almost 9%.
That tells us that the bank is still handing out very generous dividend raises.
And with a payout ratio of 45.7%, they’re positioned to continue handing out plenty more where that came from.
This is coming on top of a market-busting yield of 3.87%.
That’s more than twice as high as the yield on the S&P 500.
It’s also almost 160 basis points higher than the stock’s own five-year average yield.
The dividend metrics are checking all of the boxes.
Mouth-watering yield. Moderate payout ratio. Clear commitment to dividend growth that greatly exceeds inflation.
Of course, that’s all based on what has already happened.
But we invest in where a company is going, not where it’s been.
I’m now going to build out a forward-looking growth trajectory.
I’ll first base this on what KeyCorp has done over the last nine years (skipping FY 2009 due to heavily skewed results) in terms of top-line and bottom-line growth.
Then I’ll line that up against a professional near-term forecast for profit growth.
Blending the proven past with a future forecast like this should tell us a lot about where KeyCorp is going, which will have a lot to say about prospective dividend growth and the stock’s valuation.
KeyCorp increased its revenue from $4.465 billion in FY 2010 to $6.240 billion in FY 2018.
That’s a compound annual growth rate of 4.27%.
At first glance, that’s a very good result.
However, much of this growth was not necessarily organic in nature.
There were some minor, bolt-on acquisitions in recent years, such as the purchase of fintech firm HeroWallet in 2017.
But the acquisition of First Niagara Financial Group for $4.1 billion in 2016 was significant. That added $29 billion in deposits and approximately 300 branches to its footprint (at that time).
Revenue noticeably jumped between FY 2015 and FY 2017.
I’ll now move to profit growth on a per-share basis, which should give us a better idea of what the bank is truly capable of.
I say that because KeyCorp has issued a lot of common shares in order to help fund some of their acquisitions.
Earnings per share increased from $0.44 to $1.70 over this time period, which is a CAGR of 18.41%.
In my view, that’s remarkable.
I think it says two things.
First, the bank has greatly improved organic operations (and margins) since the Great Recession trough.
Second, the acquisitions were accretive and have been used to the bank’s advantage, even after factoring in dilution.
Looking forward, CFRA is predicting that KeyCorp will compound its EPS at an annual rate of 7% over the next three years.
This is lower than the 10% three-year EPS CAGR forecast that CFRA had in place as recently as June.
A note by CFRA in late July noted a concern over “the impact of likely declining interest rates on net interest margins and interest income over the next year.”
This has been playing out in real-time.
I think this is a fair revision. I also think it’s a reasonable growth forecast.
KeyCorp recently reported Q3 results for FY 2019, showing 6.7% YOY GAAP EPS growth (after factoring out a one-time, uncommon fraud loss).
So we’re right in that 7% ballpark here.
With the payout ratio at a moderate level, this sets shareholders up for dividend growth at least in a similar range.
The floor for dividend growth might be that 7% level over the foreseeable future. That’s if there’s no major recession.
But if the economy cruises along, I wouldn’t be surprised to see KeyCorp deliver dividend raises more in line with the one that was announced this summer. That would peg things closer to somewhere between 8% and 9% over the next few years.
Moving over to the balance sheet, the long-term debt/equity ratio is 0.88.
That’s a suitable number for the industry.
Standard & Poor’s rates their senior long-term debt at BBB+. Moody’s rates it at Baa1. Investment grade.
Showing the asset quality, KeyCorp has been publishing impressive net loan charge-offs to average total loans. Q1 and Q2 FY 2019 both came in at .29%. That’s well below the 0.47% average industry rate (per FRED). Q3 was thrown off by an aforementioned fraud loss.
Profitability is sound, although it’s not the best I’ve run across.
Over the last five years, the bank has averaged annual return on assets of 0.95% and annual return on equity of 9.05%.
Profitability has improved of late. We see that playing out in the long-term EPS growth shown earlier.
FY 2018, for instance, was outstanding. Net interest margin came in at 3.17% last fiscal year.
What we have here, in my view, is a great regional bank. One that’s become even better in recent years.
Of course, risks should be carefully considered.
Regulation, competition, and litigation are omnipresent risks in every industry. Regulation is a particular threat that’s always looming over banks.
Low interest rates remain a challenge.
Credit quality is great right now, but a deterioration there could harm profitability.
Speaking of which, a broader economic slowdown or recession is something that tends to disproportionately affect banks.
Finally, one issue that can trip up some regional banks is an aggressive expansion outside of their footprint or circle of competence. But KeyCorp’s communications regularly discuss focusing on their core competencies in their markets. Even their acquisitions tend to home in on their markets.
In my view, this is a well-run bank that offers a fantastic combination of yield and dividend growth.
At a reasonable valuation, it could be a home run of an investment over the long run.
Well, the valuation looks more than reasonable right now…
The P/E ratio is sitting at 11.82.
That’s using GAAP TTM EPS, which is actually artificially low because of a one-time loss.
Yet it still compares very favorably to the stock’s five-year average P/E ratio of 15.2.
I don’t think I even have to mention how much lower that is than the broader market’s P/E ratio.
And the yield, as noted earlier, is significantly higher than its 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 10% discount rate and a long-term dividend growth rate of 7%.
In my view, this is a conservative long-term projection.
This DDM DGR is lower than both the EPS growth and dividend growth the bank has produced over the last nine years.
And the most recent dividend increase, coming just a few months ago, is well above this mark.
A moderate payout ratio and a forecast for a 7% CAGR in EPS over the next three years sets the bank up to deliver dividend raises in the high-single-digit range.
However, low interest rates are pervasive. And we could very well be near the end of the current economic cycle.
As such, I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $26.39.
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.
This looks to me like a quality bank stock trading at a discount.
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 KEY as a 4-star stock, with a fair value estimate of $21.00.
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 KEY as a 3-star “HOLD”, with a 12-month target price of $19.00.
A bit of a spread. I came out the highest. Averaging out the three numbers gives us a final valuation of $22.13, which would indicate the stock is possibly 16% undervalued.
Bottom line: KeyCorp (KEY) is a high-quality regional bank. It’s a well-run enterprise that has become even better and stronger in recent years. With fantastic fundamentals, a market-smashing yield, a moderate payout ratio, big dividend growth, and the potential that shares are 16% undervalued, dividend growth investors should take a good look at this opportunity here.
Note from DTA: How safe is KEY’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 67. 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, KEY’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
This Will Most Likely Be the Next FAANG Stock [sponsor]
Facebook, Amazon, Apple, Netflix and Google have been the talk of the investing world for the past decade. But, what's the next big tech stock? Investing icon Louis Navellier may have the answer. Click here to see the tech stock he's pounding the table on NOW.