It’s arguably never been more challenging to be an investor.
The pandemic has created unprecedented chaos.
Some businesses are being heavily affected by this.
Yet a large number of businesses are still humming along almost as if nothing has happened.
It’s almost always a good idea to invest in vital businesses.
They tend to earn reliable, growing profit.
And that’s just the backdrop you want for reliable, growing dividends.
I’ve personally invested in many vital companies on my way to building my FIRE Fund.
That’s my real-life, real-money stock portfolio.
Not only that, I live off of that income in my 30s.
In fact, I went from below broke at age 27 to financially free at 33.
I lay out exactly how I did that in my Early Retirement Blueprint.
Suffice to say, investing was a huge part of the recipe.
But not just investing.
Investing with the right strategy, and investing in the right businesses.
The strategy is dividend growth investing.
This advocates buying and holding shares in world-class enterprises that pay reliable and rising dividends.
The Dividend Champions, Contenders, and Challengers list has data on more than 800 US-listed stocks that have raised their dividends each year for at least the last five consecutive years.
Dividend growth investing is obviously more than just selecting random stocks off of a list, though.
The right businesses are those that offer high quality at attractive valuations.
Those aforementioned businesses providing vital products and/or services often have the quality, making them desirable investments.
However, this desirability often leads to sky-high valuations.
But with the recent correction, many high-quality companies providing vital products and/or services look attractively valued.
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.
Investing in a high-quality company providing a vital need to society, and doing so at an attractive valuation, could lead to fantastic long-term results.
Fortunately, estimating intrinsic value isn’t as daunting as it might seem.
Fellow contributor Dave Van Knapp has made that even less so, via the introduction of Lesson 11: Valuation.
Part of a larger, more comprehensive series on dividend growth investing, this lesson offers a way to simply estimate value of 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…
Duke Energy Corp. (DUK) is a large US utility company. The company operates regulated utilities in the Carolinas, Indiana, Florida, Ohio, and Kentucky. They deliver electricity to 7.7 million customers.
With roots dating back to 1900, Duke Energy now sports a market cap of $60 billion.
They operate across three segments: Electric Utilities and Infrastructure, 91% of FY 2019 revenue; Gas Utilities and Infrastructure, 7%; Commercial Renewables, 2%.
I noted earlier that some businesses have barely been affected by the pandemic.
That’s because many of them are providing vital products and/or services to society.
Well, it doesn’t get much more vital than electricity.
We effectively can’t live without it.
And that’s why Duke Energy has been operating normally, more or less, straight through this national emergency.
Best of all, there’s really no competition.
Utilities operate in local monopolies.
Admittedly, even a utility company can be affected by a shutdown.
Less energy is consumed when economic activity shuts down.
However, all of those people sheltering at home are still consuming energy. It’s just that they’re doing it in a different place (at home) than they otherwise would have (at work).
Indeed, Duke Energy’s Q1 FY 2020 earnings report showed the same GAAP EPS as Q1 FY 2019. And the company maintained guidance. Effectively, there’s been little, if any, impact.
Investing in a utility company is a good idea under most circumstances.
But it might be an even better idea now.
While dividends are being suspended left and right by heavily affected businesses, utility companies are by and large paying – and even raising – their dividends as if nothing has happened.
That makes them some of the most reliable dividends in this environment.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, Duke Energy has increased its dividend for 15 consecutive years.
The 10-year dividend growth rate is a solid 2.9%.
Better yet, there’s been some signs of modest acceleration, with the five-year dividend growth rate coming in at 3.5%.
It’s not world-beating or eye-popping growth.
However, that’s coming on top of a mouth-watering yield of 4.62%.
This yield is notably more than 30 basis points higher than the stock’s five-year average.
In a world of extremely low interest rates and frequent dividend suspensions, there’s a lot to be said for a large and relatively reliable dividend.
Speaking to that reliability, besides the fact that this is a vital service, the payout ratio is 74.7%.
That’s actually not especially high for a utility. Most utilities operate with higher payout ratios, as they pass on much of their profit to shareholders in the form of cash dividends.
This dividend is awfully appealing in this environment.
Revenue and Earnings Growth
However, this is what has transpired.
Investors are putting capital at risk today for future returns.
We ultimately care most about what a company will do, not necessarily what it’s done.
Thus, I’ll now build out a forward-looking growth trajectory for Duke Energy.
This will partially rely on what Duke Energy has done over the last decade in terms of top-line and bottom-line growth.
I’ll then add in a professional prognostication for near-term profit growth.
Combining the proven past with a future forecast in this manner should allow us to reasonably extrapolate out a growth path for the company, which will help us estimate intrinsic value.
Duke Energy has increased its revenue from $14.272 billion in FY 2010 to $25.079 billion in FY 2019.
That’s a compound annual growth rate of 6.46%.
Pretty strong for a utility.
But looks can be deceiving.
Some of this growth was due to a 2012 merger with Progress Energy Inc. This merger transformed Duke Energy into the powerhouse it is today.
We can look at results on a per-share basis to get a more accurate feel for the company’s true growth. The outstanding share count did rise significantly after the merger.
Earnings per share grew from $3.00 to $5.06 over this 10-year period, which is a CAGR of 5.98%.
Bottom-line growth nearly matched top-line growth in this case, which is surprising and impressive.
Looking forward, CFRA is forecasting that Duke Energy will compound its EPS at an annual rate of 5% over the next three years.
This would be in the same neighborhood of what the company did over the last decade.
Duke Energy is obviously not in any danger of collapse – or anything close to it.
Growth will likely slow in the near term.
But in terms of long-term trends, the need and demand for electricity is not going anywhere.
I don’t think Duke Energy needs to spit out 5% annual EPS growth in order to be a great investment.
They could do less and still continue with the low-single-digit dividend raises that shareholders have been accustomed to.
If they do manage to grow at that 5% rate, fantastic. But I’d temper my expectations over the next year or two.
Moving over to the balance sheet, Duke Energy has a levered but acceptable financial position.
The long-term debt/equity ratio is 1.17, while the interest coverage ratio is slightly under 3.
These numbers are in line with what you’ll see at many of the large utility companies.
They provide a necessary service that guarantees revenue.
But this is a regulated business model. There’s a lot of government oversight here, capping growth and authorizing rate increases when required.
Regulation constrains profitability to a degree.
Over the last five years, the firm has averaged annual net margin of 12.02% and annual return on equity of 6.86%.
These are good numbers for a regulated utility.
I think it’s always a smart idea to have utility exposure in your portfolio.
It’s arguably an even smarter idea right now.
There are few dividends out there safer than those from a regulated utility.
Utilities are still providing their necessary energy services. This is during a time in which some industries are being mandated to close.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
Competition is practically eliminated in the utility space due to monopolistic geographic footprints. However, increasing use of solar at the point of usage creates a viable alternative.
Any rise in interest rates will be a negative for the company, as higher rates make debt more expensive and equity less attractive.
Also, the regulation could harm the company over the near term due to political resistance on requests for increases in base rates during a challenging time for society.
Even with these risks, a regulated utility like Duke Energy could be a fantastic long-term investment.
It could be even more fantastic after a 21% pullback from its 52-week high, with the stock now looking undervalued…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 16.05.
That’s well off of the stock’s five-year average P/E ratio of 20.8.
The cash flow also shows a disconnect, with the P/CF ratio of 7.3 being measurably lower than its own three-year average of 8.8.
And the yield, as shown earlier, is higher than its recent historical average.
So the stock looks cheap when looking at basic valuation metrics. But how cheap might it be? What would a rational 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 4%.
That dividend growth rate is slightly higher than the company’s DGR over the last five years.
On the other hand, it’s lower than the long-term EPS growth rate, as well as the forecast for near-term EPS growth.
With a sensible payout ratio, I don’t think it’s a stretch for Duke Energy to compound its dividend at a 4% annual rate from here.
The DDM analysis gives me a fair value of $78.62.
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 came up with an analysis that shows the stock roughly fairly valued.
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 DUK as a 4-star stock, with a fair value estimate of $95.00.
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 DUK as a 4-star “BUY”, with a 12-month target price of $93.00.
I came out the lowest. Perhaps I was too conservative. Averaging the three numbers out gives us a final valuation of $88.87, which would indicate the stock is possibly 9% undervalued.
Bottom line: Duke Energy Corp. (DUK) is a company providing a vital service to society and more or less unaffected by the national emergency. And they do so via local monopolies. That makes its market-smashing dividend more secure than others. With a 4.6% yield, a sensible payout ratio, 15 consecutive years of dividend raises, and the potential that shares are 9% undervalued, this is a stock that dividend growth investors should strongly consider picking up while it’s on sale.
Note from DTA: How safe is DUK’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 80. 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, DUK’s dividend appears Safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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