Most Americans love shopping at malls and websites.
But there’s only one store I get excited about.
That store is the stock market.
The stock market is my favorite store.
And stocks are my favorite merchandise.
I’ll tell you why.
Whereas most stuff depreciates and turns into useless junk over time, stocks tend to appreciate.
That’s because stocks represent ownership in real businesses.
And high-quality businesses usually increase their profit over time, which increases the value of the businesses and their shares.
Best of all, many of the world’s best businesses are sharing some of that growing profit directly with their shareholders.
That occurs via growing cash dividends.
You can find more than 800 US-listed stocks doing this by taking a look at the Dividend Champions, Contenders, and Challengers list.
Clothes in your closet won’t provide you with income. But many stocks will.
This is a big reason why I’m a dividend growth investor.
I’ve used my favorite merchandise to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
By abstaining from malls and e-commerce, I instead plowed my money into high-quality dividend growth stocks.
And I built the FIRE Fund in the process.
That real-money portfolio generates the five-figure passive dividend income I now live off of.
Just like with any other merchandise, though, you want to pick up stocks when they’re “on sale”.
After all, it’s price that you pay.
But it’s value that you get.
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.
Buying a high-quality dividend growth stock when it’s undervalued can provide you with a life-changing piece of merchandise.
Fortunately, it’s not that difficult to spot the sales.
Sure, there aren’t flyers sent to your mailbox.
However, a little bit of legwork goes a long way.
Fellow contributor Dave Van Knapp has made that legwork far easier, via the introduction of Lesson 11: Valuation.
Part of a larger, more comprehensive series of “lessons” on DGI, Lesson 11 puts forth a valuation template that you can apply 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…
United Parcel Service, Inc. (UPS)
United Parcel Service, Inc. (UPS) is the world’s largest parcel delivery company, using more than 500 planes and 100,000 vehicles to deliver millions of packages to residences and businesses worldwide.
Founded in 1907 as a US messenger company, they now manage the flow of goods, funds, and information in more than 200 countries and territories.
The company’s FY 2018 revenue breaks down across the following segments: U.S. Domestic, 61%; International, 20%; Supply Chain and Freight, 19%.
Speaking of shopping and merchandise, let’s talk about UPS.
This company is directly benefiting from the massive rise of e-commerce.
All of those boxes getting slung around from businesses to consumers need logistics companies like UPS to facilitate the shipping.
As consumers around the world continue to fulfill their insatiable need for more merchandise, investors are able to pick up stock in UPS and really stock up on some quality long-term merchandise.
Meanwhile, UPS is paying you to do so.
Dividend Growth, Growth Rate, Payout Ratio and Yield
In fact, they’re paying you more and more… every year.
As it sits, the company has increased its dividend for 10 consecutive years.
The 10-year dividend growth rate is a stout 7.9%.
There has been a slight deceleration of dividend growth in recent years, with the most recent dividend increase coming in at under 6%.
However, that growth comes on top of a starting yield of 3.66%.
This yield is about twice as high as what the broader market offers. It’s also more than 50 basis points higher than the stock’s own five-year average yield.
And with a payout ratio of 50.1% on adjusted EPS, the dividend appears to be very secure.
A big and safe dividend isn’t so easy to come by in a stock market store that has arguably become expensive.
But in order to determine just what kind of deal we might have here, we need to estimate intrinsic value.
I’ll build out a growth trajectory in order to work out that estimate, since the value of any company is ultimately the discounted sum of all future cash flow.
I’ll first show you what UPS 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 profit forecast.
Blending the proven past with a future forecast in this manner should allow us to approximate where the company is going.
Revenue and Earnings Growth
UPS grew its revenue from $49.545 billion to $74.094 billion between FY 2010 and FY 2019.
That’s a compound annual growth rate of 5.33%.
I usually look for mid-single-digit top-line growth from a mature firm such as this.
UPS delivered. And then some.
This is a strong result, although the larger base (coming up on $75 billion now) will mean it’s that much more difficult to continue growing at a similar rate.
Meanwhile, earnings per share expanded from $3.33 to $7.53 over this time frame, which is a CAGR of 9.51%.
Big share buybacks have helped their cause; the outstanding share count is down by ~13% over the last decade.
Admittedly, I did use an adjusted EPS figure for FY 2019. That’s because of an extremely large MTM pension charge that heavily skewed results for the most recent fiscal year.
Plenty of top-line and bottom-line growth to be had here, no matter how you slice it.
It’s pretty impressive stuff.
Looking forward, CFRA is anticipating that UPS will compound its EPS at an annual rate of 12% over the next three years.
They cite a better trade environment, improving industry capacity, and an expanding revenue base as key tailwinds.
However, they have noted some weakness in Freight, and the trade environment does remain a bit uncertain.
Adding color to this projection, the top end of the company’s 2020 guidance for adjusted EPS would add up to ~7% YOY growth.
I find the 12% growth forecast aggressive, but UPS could certainly surprise.
But UPS doesn’t need to grow at 12% in order to be a suitable investment right now.
Assuming a static valuation, the sum of yield and dividend growth should equal total return.
With that starting yield of over 3.5%, UPS needs only to grow earnings and the dividend in the high-single-digit range in order to provide lots of aggregate income and an annualized ~10% total return.
And I think that’s exactly what investors should expect: UPS looks situated to deliver 6% to 8% dividend raises for the foreseeable future, based on company growth and the payout ratio.
Financial Position
Moving over to the balance sheet, UPS has a solid financial position.
That position has been better, though. And it could stand to be improved. But the balance sheet is not in any kind of trouble whatsoever.
The long-term debt/equity ratio, at 9.16, is extremely high.
However, that’s largely due to low common equity. It’s not because the long-term debt is out of control.
Furthermore, the interest coverage ratio comes in at over 9, indicating no problems with covering interest expenses.
Profitability is robust for the industry.
Over the last five years, the company has averaged annual net margin of 6.97% and annual return on equity of 291.28%.
The ROE offers us no insight. It’s only so high because of the aforementioned low common equity.
But the net margin is highly competitive for the industry. And it’d look even better were it not for frequent impacts to GAAP EPS.
There’s a lot to like about UPS.
The stock is an excellent piece of merchandise. And as more consumers around the world buy more of their traditional merchandise online, logistics companies like UPS stand to directly benefit.
Massive scale, a global network, cost efficiency, and high barriers to entry are durable competitive advantages that protect the business. It’s nigh impossible to replicate the company’s infrastructure from scratch.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
A global recession would reduce demand for consumption and shipping, impacting the company.
Lingering trade concerns are weighing on the company’s ability to plan and invest.
And the rise of Amazon.com, Inc. (AMZN) as a competitor could be a double whammy.
Amazon has been busy building out its own shipping fleet. This could mean the loss of revenue from one of the largest e-commerce players, as well as an additional competitive threat. It says a lot that it takes a $1 trillion company to threaten UPS, but it’s a new risk.
Overall, though, I view UPS as a low-risk business model.
Stock Price Valuation
At the right price, it could be a fantastic long-term investment.
Well, the stock’s valuation looks compelling after an 18% drop from fall highs…
The stock’s P/E ratio is 13.93.
That’s based on adjusted TTM EPS.
This is obscenely low in the current market. It’s also well off of the stock’s own five-year P/E ratio average of 22.8.
Admittedly, that P/E ratio average has been skewed by frequent charges.
But check this out.
The P/CF ratio, sitting at 10.5 right now, is almost half of its three-year average of 19.1.
And the 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 10% discount rate and a long-term dividend growth rate of 7%.
This DGR is obviously quite a bit lower than what UPS has delivered over the last decade.
However, recent dividend growth has slowed a tick.
And it’s better to err on the side of caution when modeling out growth over the very long term.
I think UPS could exceed this mark, but there’s no need to be aggressive on the valuation in this market.
The DDM analysis gives me a fair value of $136.96.
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 was arguably being cautious with the valuation, yet the stock still looks very 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 UPS as a 3-star stock, with a fair value estimate of $111.00.
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 UPS as a 5-star “STRONG BUY”, with a 12-month target price of $140.00.
We’re in agreement here regarding the stock being worth more than its current price. Averaging the three numbers out gives us a final valuation of $129.32, which would indicate the stock is possibly 23% undervalued.
Bottom line: United Parcel Service, Inc. (UPS) is a high-quality, global behemoth. It’s perfectly positioned to capture increasing profits from the rise of e-commerce. That should translate to more dividends for shareholders. With a market-beating 3.5%+ yield, 10 consecutive years of dividend raises, strong dividend growth, a moderate payout ratio, and the potential that shares are 23% undervalued, this looks like a great piece of “merchandise” from my favorite store.
-Jason Fieber
Note from DTA: How safe is UPS’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 69. 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, UPS’s dividend appears Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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