February 2020 was a month for the ages.
The S&P 500 corrected rather swiftly after COVID-19 became more widespread outside of mainland China.
In fact, it was the fastest 10% drop from an all-time high in the index’s entire history.
Well, there’s only one word that comes to mind when I see this.
You’d surely be thrilled to see the cost of food come down by 10%.
Unless you’re in retirement and drawing down your portfolio, a stock market sale is a tremendous opportunity to buy merchandise at lower prices.
However, it’s just important as ever to pick out the right opportunities.
In my mind, the right opportunities are high-quality dividend growth stocks.
World-class enterprises that can be found on the Dividend Champions, Contenders, and Challengers list tend to make excellent long-term investments.
Not only that, but these stocks provide reliable and rising passive income, via the growing cash dividends they pay shareholders.
Indeed, I’ve used dividend growth investing to retire in my early 30s, as I lay out in my Early Retirement Blueprint.
Living off of dividends in your 30s.
It’s no pipe dream.
But I do feel like I’m living a dream.
The five-figure passive dividend income my FIRE Fund generates for me is enough to cover my essential expenses in life.
That Fund is my real-money portfolio, and it’s chock-full of high-quality dividend growth stocks.
However, it’s not just high-quality dividend growth stocks that you should be looking at.
Price is only what you pay. 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.
Undervalued high-quality dividend growth stocks can be the best opportunities in the entire market.
Fortunately, ascertaining an estimate of a stock’s value isn’t that difficult.
Fellow contributor Dave Van Knapp made it even easier with Lesson 11: Valuation, a valuation template that you can apply to almost 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…
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 loan portfolio, at $962 billion, is 54% commercial and 46% consumer. Total loans grew at 1% YOY.
The company reports results across three segments: Community Banking, 53% of FY 2019 revenue; Wholesale Banking, 33%; and Wealth and Investment Management, 20%. Other accounted for -6%.
Community Banking offers diversified financial products and services for consumers and small businesses.
Wholesale Banking provides financial solutions to businesses with annual sales usually in excess of $5 million and to financial institutions globally.
Wealth and Investment Management provides a range of personalized wealth management, investment, and retirement products and services to clients through a group of US-based banking subsidiaries.
Wells Fargo is one of the biggest banks in one of the biggest and most profitable financial markets in the history of humankind.
Banking has long been one of the best business models out there, due to the way they make money from other people’s money.
Specifically, a high-quality bank can build a significant “float”, which 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.
Putting it to work translates into growing profit.
And growing profit translates into growing dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Indeed, Wells Fargo has increased its dividend for nine consecutive years.
Like many US banks, they were forced to reduce their dividend during the GFC.
However, they’ve made up for past sins in a big way.
The 10-year dividend growth rate is 14.6%.
And the most recent dividend increase, at over 13%, shows that things aren’t slowing down.
With a payout ratio of 50.4%, they’re situated well to continue growing the dividend.
That payout ratio, by the way, is what I like to refer to as a “perfect” payout ratio.
It’s a perfect balance between retaining profit for business growth and returning cash to shareholders in the form of a cash dividend.
On top of this payout ratio and growth, the stock offers a market-smashing yield of 5.45%.
That’s more than twice as high as the broader market.
It’s also almost 250 basis points higher than the stock’s own five-year average yield.
There’s much to like about what’s been happening with the dividend.
Of course, we invest in where a company is going, not where it’s been.
I’ll now build out a forward-looking growth trajectory, which will later help us estimate the intrinsic value of the stock.
Revenue and Earnings Growth
Relying first on a 10-year track record of top-line and bottom-line growth, I’ll compare these results to a near-term professional prognostication for profit growth.
Blending the proven past with a future forecast in this manner should tell us a lot about where the bank might be going.
Wells Fargo grew its revenue from $84.431 billion in FY 2010 to $85.063 billion in FY 2019.
Revenue is basically flat here.
Not what I’d typically like to see – I’d usually prefer to see mid-single-digit top-line growth from a mature business like this.
However, the last decade has been unusually challenging for banks in general. Low interest rates have been pervasive, limiting the power of these sizable floats. In addition, global economic growth coming out of the Great Recession has been somewhat anemic and slow burning.
Furthermore, Wells Fargo has plagued itself through a slew of scandals that hurt its reputation, most notably with the fraudulent opening of accounts that saw Wells Fargo employees creating millions of savings and checking accounts on behalf of bank clients without their consent.
Wells Fargo has been moving past these mistakes and righting past wrongs to the best of their ability. Notably, toward that end, the bank recently agreed to pay $3 billion resolve the US DOJ’s and SEC’s investigations into the company’s retail sales practices. This comes shortly after bringing on outsider CEO Charles Scharf.
So the bank did kind of “shoot itself in the foot”.
Fortunately, they’re such a large and profitable financial institution, that they’re still basically printing money.
And because they’re such a prolific purchaser of their own shares, reducing the outstanding share count by approximately 16% over the last 10 years, they’ve been able to move the needle on the bottom line.
Earnings per share increased from $2.21 to $4.05 over this period, which is a CAGR of 6.96%.
This bottom-line growth has helped the bank increase the dividend without causing the payout ratio to get too high.
Looking forward, CFRA is predicting that Wells Fargo will compound its EPS at an annual rate of 5% over the next three years.
CFRA cites low interest rates as a key problem. The Federal Reserve’s decision to lower the federal funds rate by 0.5% just this past Tuesday doesn’t help the bank’s case.
On the other hand, lower rates may spur economic activity, especially in terms of loans. Mortgage origination and refinancing, in particular, may start to heat up as a result of such low rates.
The near-term growth picture isn’t super exciting. I’ll admit that.
But Wells Fargo’s scale and market positioning does work to its advantage over the long run.
It’s anyone’s guess where interest rates will go over the next 10 years. However, I think there’s a lot to be said for the last 10 years. Wells Fargo compounded its EPS at almost 7% annually through what was one of the most challenging periods the bank has ever had.
If low rates, an anemic global recovery, and scandals bring things down to “just” 7%, there should be a lot to look forward to over the next few decades.
With the low payout ratio and big buybacks, the bank is set up to easily hand out high-single-digit dividend raises for the foreseeable future. Perhaps even better than that. But with that big yield, investors shouldn’t develop unreasonable expectations.
The long-term debt/equity ratio is 1.22, which is in line with other large US banks.
Senior debt is rated as following: A2, Moody’s; A- Standard & Poors; A+ Fitch. Well into investment-grade territory.
Profitability is robust.
Over the last five years, the bank has averaged annual return on assets of 1.08% and annual return on equity of 11.67%. Net interest margin came in at 2.73% for FY 2019.
Overall, I think Wells Fargo is a high-quality business.
The bank has seen better days. But the clouds appear to be clearing. A new CEO and the recent settlements have added some much-needed sunshine to the landscape.
Moreover, scale, switching costs, and a ~$2 trillion asset base give it sizable and durable competitive advantages.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The falling interest rate environment in the US is a big concern, as this constrains the bank’s ability to earn a profit.
Any kind of recession, particularly in the United States, would directly and substantially impact Wells Fargo.
They own a damaged reputation.
And the bank’s size, while an advantage, does in some ways work against it. This is especially the case in the retail footprint, which could be a liability as more banking operations move online.
Overall, I view Wells Fargo to be an appealing long-term opportunity for dividend growth investors.
But that’s especially so after the stock has fallen 23% just from the start of the year.
It now looks downright cheap…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 9.24.
That’s well below where the broader market is at.
It’s also much lower than the stock’s own five-year average P/E ratio of 12.7.
Also, the sales multiple, at 2.1, is way off of the stock’s five-year average P/S ratio of 3.1.
And the yield, as shown earlier, is materially 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 high yield) and a long-term dividend growth rate of 5.5%.
This DGR is cautious. It’s arguably too conservative.
With a “perfect” payout ratio, and a long-term EPS and DGR well above this level, it’s likely they’ll do better than this.
However, I’m factoring in the 5% EPS growth rate from CFRA and the numerous question marks regarding interest rates. We’re in unprecedented territory regarding global interest rates. And it’s impossible to quantify how that’ll affect global financial institutions.
I’d rather err on the side of caution.
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.
Even with erring so far on the side of caution, the stock still looks extremely undervalued.
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 $56.00.
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 $42.00.
I came out a bit high, which is surprising. Averaging the three numbers out gives us a final valuation of $53.16, which would indicate the stock is possibly 42% undervalued.
Bottom line: Wells Fargo & Co. (WFC) is a high-quality company with unique and durable competitive advantages. They’re finally moving on from past mistakes, and the future looks brighter than it has in a long time. With a yield near 5%, double-digit long-term dividend growth, a “perfect” payout ratio, and the potential that shares are 42% undervalued, dividend growth investors should take a very close look at this stock right now.
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.
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