I came across a great quote by Jeff Bezos recently.
“Big things start small.”
He’d know a lot about turning something small into something really big.
Likewise, this is a theme that repeats itself across our lives.
And if you get in while they’re still small, you stand to make a ton of money.
Best of all, you don’t need to solely rely on higher stock prices and capital gain.
Many of the world’s best businesses that are capturing growth from global themes are paying out reliable and rising cash dividends.
This allows you to earn easy income from your investments without selling off stock.
You can find hundreds of examples on the Dividend Champions, Contenders, and Challengers list.
I’ve personally invested in a number of these businesses, as you can see in my real-money FIRE Fund.
And the five-figure passive dividend income these businesses are collectively paying me is enough to cover my bills.
Investing has freed me. I’m financially independent.
In fact, I was able to retire in my early 30s.
I lay out exactly how I did that in my Early Retirement Blueprint.
The investment strategy I used, dividend growth investing, was paramount to my success.
This strategy advocates buying and holding shares in high-quality companies that pay growing dividends.
Simple as that.
I was once broke. Worse, actually. I was worth less than $0.
But big things start small.
You can build a rather large portfolio for yourself by starting with little money.
Dividend growth investing can help you do that.
Of course, you have to be intelligent with the way you go about selecting dividend growth stocks.
Valuation at the time of investment is critical.
While the price is what a stock costs, value is what a stock is worth.
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 high-quality dividend growth stocks when they’re undervalued can allow you to start small and eventually build a big portfolio.
The good news is, undervaluation is far from impossible to find.
Fellow contributor Dave Van Knapp made that even easier, via the introduction of Lesson 11: Valuation.
Part of a comprehensive series on dividend growth investing, this “lesson” describes a valuation process 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…
WestRock Company (WRK)
WestRock Company (WRK) is a leading integrated manufacturer of various corrugated and consumer packaging materials.
The company was formed through the 2015 merger between Rock-Tenn and MeadWestvaco.
With more than 320 manufacturing facilities across the world, WestRock Company has become one of the world’s largest producers of corrugated medium and linerboard. They sell these products to more than 15,000 customers.
Producing various paper products such as containerboard, folding cartons, and displays, the company’s packaging solutions are an integral part of end markets ranging from foodservice to healthcare.
WestRock reports in two primary segments: Corrugated Packaging, 65% of FY 2019 sales; and Consumer Packaging, 36%. Intersegment Eliminations accounted for -1%.
Big things start small.
Well, there are two growing global investment themes that WestRock is directly exposed to and profiting from.
They started small. But they’re getting bigger.
The first theme relates to Jeff Bezos himself: e-commerce.
Those boxes carrying the stuff that people are ordering online are manufactured by companies like WestRock.
More stuff equals more boxes and more money.
The second theme is the move from plastic to paper.
You see this in straws, bags, and packaging.
Consumers are backing away from plastic in a major way.
That plays right into WestRock’s hands.
And it could play right into your hands, too – if you’re a shareholder.
I mean “into your hands” in a literal sense, by the way.
Dividend Growth, Growth Rate, Payout Ratio and Yield
That’s because WestRock is paying out a large and growing dividend, which provides tangible cash flow.
They’ve increased their dividend for 11 consecutive years.
The 10-year dividend growth rate is a stout 24.6%, but much of that came on the back of an expanding payout ratio.
More recent dividend raises have been in the mid-single-digit range.
However, with a monstrous yield of 5.86%, investors don’t need huge dividend increases to make sense of this investment in terms of both income and total return.
Keep in mind, this yield is almost 250 basis points higher than the stock’s own five-year average yield.
Plus, with a payout ratio of 56.0%, the dividend is easily covered and in a good position to continue growing.
Of course, we invest in where a company is going, not where it’s been.
It’s that future growth and those future dividend increases we care most about.
Thus, I’ll now build out a forward-looking growth trajectory for the business, which will later help us value the stock.
Revenue and Earnings Growth
I’ll first show you what WestRock has done in the recent past in terms of top-line and bottom-line growth. This will help us build a foundation for the growth model.
I usually use a 10-year track record, but WestRock as we now know it did not exist until 2015 (due to the aforementioned merger). Thus, I’ll only look at growth from 2015 onward.
Then I’ll reveal a professional forecast for near-term profit growth.
Blending the proven past with a future forecast in this manner should tell us a lot about where WestRock might be going.
WestRock increased its revenue from $11.381 billion in FY 2015 to $18.289 billion in FY 2019.
That’s a compound annual growth rate of 12.59%.
In my view, this is pretty impressive.
I tend to look for mid-single-digit top-line growth from a mature company. WestRock blew that out of the water.
But I think it’s difficult to draw too many conclusions from this because of the short time frame.
Moreover, the company recently acquired KapStone Paper and Packaging Corporation for $4.8 billion, further skewing results.
Meanwhile, earnings per share grew from $2.93 to $3.33 over this period, which is a CAGR of 3.25%.
Bottom-line growth is well off of revenue growth. I think the truth lies somewhere between these numbers.
Said another way, WestRock looks capable of mid-single-digit growth once everything settles down.
EPS was hurt by the big jump in outstanding shares, relating to the KapStone acquisition.
The good news is that WestRock is targeting $200 million in synergies by the end of FY 2021, which they’re on pace for.
Looking forward, CFRA believes that WestRock will compound its EPS at an annual rate of 3% over the next three years.
They cite higher volume in containerboard and the global moving away from plastic as key tailwinds for the business.
But these tailwinds are offset by lower containerboard prices due to industry dynamics at the current moment. In addition, WestRock faces a lot of volatility as it relates to the cost of raw materials.
It’s difficult to accurately gauge WestRock’s future growth because they simply haven’t had much time to stand on their own two feet. They’ve been digesting M&A since 2015.
But I do think that CFRA’s forecast is a conservative baseline figure. With the two global megatrends that this company is taking advantage of, it seems likely to me that they’ll exceed this 3% growth forecast.
And they don’t have to exceed it by much to deliver mid-single-digit dividend growth.
Pairing 5%+ dividend growth with a 5%+ yield is awfully attractive, in my view.
Moving over to the balance sheet, this is probably the weakest area of the business.
The long-term debt/equity ratio is 0.81, while the interest coverage ratio is under 4.
Total cash is immaterial.
I’d like to see that interest coverage ratio get above 5 very soon. I see that as a kind of a “line in the sand” as it relates to a company’s ability to cover its ongoing interest expenses. Below 2 is immediate trouble.
The balance sheet could be greatly improved. It’s not an emergency type of situation, but I think WestRock should reduce debt over the coming years now that the synergies from the accretive KapStone acquisition are being realized.
Profitability is solid, although it’s difficult to work out exactly where WestRock stands.
The merger between Rock-Tenn and MeadWestvaco was completed in mid-2015.
And then the KapStone acquisition was completed in November 2018.
There are a lot of moving parts here. But what they’ve posted is very good.
I’d like to see even better margins. However, I see the balance sheet as the biggest area for improvement.
A lot to like about WestRock, especially with the way the world is likely to consume much more paper in the years ahead.
And their scale gives them a competitive advantage and the ability to rise to the challenge.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
It’s a capital-intensive and cyclical industry, with volatile input costs.
Those volatile input costs are beyond the company’s control. And higher costs for raw materials are difficult to pass on because of the commodity-like nature of the business.
Any global recession would undoubtedly reduce demand for their products, as less commerce means less paper consumption.
Interest rates are currently extremely low. This helps an indebted company like WestRock. But any rise in interest rates would impair their ability to repay debt.
And the KapStone acquisition was rather large relative to the size of WestRock. It’s imperative that this acquisition works out well for the company in terms of cash flow against the cost.
Overall, WestRock looks like a strong long-term investment that exposes shareholders to two global megatrends.
Stock Price Valuation
At the right price, this could be a fantastic purchase in this market.
Well, with a ~15% pullback since the end of last week, the stock looks very attractively valued now…
Shares are trading hands for a P/E ratio of only 9.51.
That’s significantly lower than the broader market.
Now, earnings can cloud the valuation. WestRock’s GAAP earnings have been all over the place in recent years.
However, drilling down into cash flow still shows a very low valuation.
The P/CF ratio, at 3.7, is materially lower than the stock’s own three-year average P/CF ratio of 6.6.
And the yield, as noted earlier, is substantially 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 an 8% discount rate (due to the high yield) and a long-term dividend growth rate of 4%.
This DGR is well off of WestRock’s own proven long-term DGR.
But recent dividend raises have been in this range.
When I look at the EPS growth over the last few years, as well as CFRA’s near-term growth projection, I think a 4% dividend growth rate is a fair expectation from this business.
The payout ratio remains moderate. And FCF has been easily covering the dividend.
I think it’s possible that WestRock will exceed this mark. But I would set the bar low. One doesn’t need to extrapolate out a lot of growth when the yield is so high.
The DDM analysis gives me a fair value of $48.36.
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.
Even with what was arguably a conservative valuation, the stock still looks incredibly 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 WRK as a 4-star stock, with a fair value estimate of $51.00.
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 WRK as a 4-star “BUY”, with a 12-month target price of $47.00.
We have a pretty tight consensus here. Averaging the three numbers out gives us a final valuation of $48.79, which would indicate the stock is possibly 54% undervalued.
Bottom line: WestRock Company (WRK) is perfectly positioned to take advantage of two global megatrends. These trends started small, but big things start small. With a market-smashing 5%+ yield, more than 10 consecutive years of big dividend raises, a moderate payout ratio, and the potential that shares are 54% undervalued, this dividend growth stock should be seriously considered by long-term investors.
Note from DTA: How safe is WRK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 51. 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, WRK’s dividend appears Borderline Safe with a low risk of being cut. Learn more about Dividend Safety Scores here.
With accelerating inflation and declining stocks, you likely need a different investing approach. A 20-year market veteran shares an easy one-step plan, including details on his No. 1 GOLD recommendation today, right here.