I’ve been investing for a decade.
And if there’s one thing I’ve learned, it’s that successful investing is counterintuitive.
The easiest time to invest – when things are great and stocks are expensive – is also the worst time to invest.
Having the mental strength to realize and overcome this is what leads to vast amounts of wealth and passive income over time.
I haven’t always gotten it right, but I’ve done my best to do so as I built out my FIRE Fund.
That’s my real-money stock portfolio.
In fact, I’m living off of passive income in my 30s.
I was able to retire so early in life by living below my means and using dividend growth investing, as I describe in my Early Retirement Blueprint.
Dividend growth investing advocates buying and holding shares in high-quality businesses that pay reliable and rising cash dividends.
You can find more than 800 US-listed dividend growth stocks by checking out the Dividend Champions, Contenders, and Challengers list.
Of course, that list, while highly informational and valuable, is just a list.
It’s the individual investor’s responsibility to decipher the information.
An investor must fundamentally analyze and value a business before investing hard-earned capital.
That latter part – valuation – is especially critical.
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.
Overcoming the counterintuitive nature of stocks and buying a high-quality dividend growth stock after it’s been beaten down into undervaluation territory can lead to tremendous long-term results.
Fortunately, valuing stocks isn’t as hard as it might seem.
Fellow contributor Dave Van Knapp has made that even easier with Lesson 11: Valuation.
Part of a more comprehensive series of “lessons” on dividend growth investing, it lays out 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…
JPMorgan Chase & Co. (JPM) is a financial holding company that operates as one of the largest financial institutions in the United States, with over $2.5 trillion in assets. They offer various financial products and services across traditional retail and commercial banking, asset management, and investment banking.
Founded in 1799, the bank has a fabled corporate history, intertwining with such magnates as J.P. Morgan, John D. Rockefeller, Thomas Edison, and Andrew Carnegie.
JPMorgan Chase is now a $270 billion institution (by market cap) that employs almost 300,000 people across the world.
The bank operates across four major business lines: Consumer & Community Banking, 48% of FY 2019 revenue; Corporate & Investment Bank, 33%; Asset & Wealth Management, 12%; Commercial Banking, 8%. They also have a Corporate business segment that results in insignificant revenue.
This bank is massive. The economic infrastructure of the United States can’t viably operate without this institution.
From retail branches to credit cards to the financial markets, JPMorgan Chase touches every facet of US finance.
Here’s how Morningstar describes the bank:
“JPMorgan has emerged as arguably the most dominant bank in the United States. With leading share in many aspects of banking and financial services, the bank should be in an advantaged position for years to come.”
If you think the economy of the United States will prosper over the long run, then you have to simultaneously believe that JPMorgan Chase will prosper over the long run. It’s almost impossible to separate the two.
Admittedly, though, banks are basically in the “eye of the storm” right now.
They’re going to be directly affected by the pandemic, as they form the financial backbone of the economy. There’s no way for a large bank to completely avoid losses from bad loans when you have this kind of health and economic crisis.
However, this relates back to what I noted at the outset of today’s article.
It’s difficult to invest in banks right now.
As a result, it might just be the best time to invest in banks.
I’ll give you two reasons for that.
First, large banks are set up to lead the recovery. As the economy returns to normal, banks will be there to soak up all of that new business.
That bodes well for their ability to grow their dividends over the long run.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it sits, they’ve increased their dividend for nine consecutive years.
The five-year dividend growth rate is 16.2%, which is obviously stellar.
That monstrous growth comes on top of a yield of 3.94%.
Snagging a ~4% yield with double-digit dividend growth is no easy or common feat.
By the way, that yield is almost twice as high as what the broader market offers.
Furthermore, it’s more than 160 basis points higher than the stock’s five-year average yield, relating back to what I noted earlier about valuation and yield.
The dividend does remain protected by a payout ratio of 40.7% – and that’s even after JPMorgan Chase took a huge loss in Q1 2020 to build reserves.
While there’s no guarantee that politics won’t pressure the company on their dividend at some point, especially if the health crisis gets worse, the bank remains fundamentally sound.
Revenue and Earnings Growth
Now, that’s all looking at what the bank has already done.
But investors put capital at risk for what’s to come. We invest for tomorrow’s results and gains.
So I’ll now build out a forward-looking growth trajectory for the bank, which will later help us value the stock.
I’ll first show you what they’ve done over the last decade in terms of top-line and bottom-line growth.
Then I’ll compare that to a near-term professional prognostication for earnings growth.
Combining the proven past to a future forecast in this manner should allow us to extrapolate out some reasonable assumptions about where the bank is going.
JPMorgan Chase grew its revenue from $102.694 billion in FY 2010 to $115.627 billion in FY 2019.
That’s a compound annual growth rate of 1.33%.
Not a huge growth rate, but it is tough to move a top line forward when it’s starting out at over $100 billion.
Meanwhile, earnings per share advanced from $3.96 to $10.72 over this period, which is a CAGR of 11.70%.
That’s more like it.
A ~19% reduction in the outstanding share count over the last 10 years certainly helped create some excess bottom-line growth, but much of this is simply due to the bank improving across all aspects of the business.
JPMorgan Chase is run by Jamie Dimon, who’s routinely heralded as one of the best bank managers in the world.
I think the delta between revenue growth and profit growth goes some way toward explaining why that is. They’re one of the best-run banks out there.
Looking forward, CFRA is projecting 5% compound annual growth for the bank over the next three years.
This would be a notable drop from what the company has produced over the last decade, but I think it’s correct to be cautious here.
CFRA’s projection was put out on April 14, which is well after the effects of the pandemic were becoming apparent.
And those effects aren’t just felt across the broader economy and bad loans.
The Federal Reserve has also slashed interest rates, which puts further pressure on the spread that banks rely on for profit.
This compresses net interest income and net interest margin.
A 50%+ drop in near-term EPS growth seems warranted, although I still think this bank will do better than that once things return to some kind of normal.
Either way, the dividend is covered. And it wouldn’t take much bottom-line growth to further bolster the dividend and even allow for some modest dividend raises until the bank is in a better position to grow it in a more routine fashion.
Moving over to the balance sheet, JPMorgan Chase has one of the biggest and most complex makeups of all institutions.
This can make it difficult to decipher exactly what’s going on.
On the other hand, it gives them scale in an industry where scale matters, and scale becomes even more important when times of stress (like right now) occur.
JPMorgan Chase retains the following credit ratings: A2, Moody’s; A-, Standard & Poors; AA-, Fitch. These ratings are well into investment-grade territory.
Profitability is outstanding.
The bank routinely puts up robust numbers that are better than the competition in almost every way.
Over the last five years, the firm has averaged annual net margin of 22.73% and annual return on equity of 11.08%. Net interest margin came in at 2.46% for last fiscal year.
Overall, there’s so much to like about JPMorgan Chase.
They have scale where scale matters, conferring a durable competitive advantage. And banks naturally have “sticky” assets, whereby customers typically are loath to switch banks due to the difficulty in changing their financial setup.
With almost $3 trillion in assets and a near-pristine reputation, the bank is essentially the “king of the hill”.
Of course, there are risks to consider.
Competition, regulation, and litigation are omnipresent risks in every industry.
Banks are highly exposed to economic cycles. The upcoming pandemic-induced recession will hurt JPMorgan Chase to an unknown degree.
While the sheer size of the bank is an advantage, it also limits their growth prospects by virtue of the law of large numbers.
Low interest rates, which now appear to be here to stay for some time, hurt the profitability of banks. Even a well-run bank will be capped on growth.
With these risks known, I still think JPMorgan Chase looks like a great long-term investment.
It’s scary to invest in banks right now, which might just be why it’s a great time to do so.
I said there are two reasons for this. I gave you one reason earlier.
Well, here’s the second reason: Bank stocks have been absolutely hammered throughout the stock market rout.
That means a lot of risk and bad loans, which may or may not come to be, have been already priced in.
This stock is now down 35% YTD, which has knocked its market cap down by a stunning $166 billion!
So the market is now valuing the bank at $158 billion less than before, which is assuming there’s going to be tremendous losses. You already have a very bad outcome priced in.
This huge drop has led to what looks like an appealing valuation…
Stock Price Valuation
The stock is available for a P/E ratio of 10.31.
This is much lower than the broader market.
It’s also well off of the stock’s five-year average P/E ratio of 12.8.
For a best-in-breed bank, that’s absurdly low.
The P/B ratio is 1.2.
The current P/S ratio, at 2.5, compares very well to the five-year average of 3.2.
And the yield, as noted earlier, is substantially 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 10% discount rate and a long-term dividend growth rate of 6.5%.
This is a rather middling dividend growth rate for a top-notch bank like this, as they’ve done so much better than this over the last decade, but I think it makes sense to err on the side of caution.
I fully recognize that dividend growth will be challenging, to say the least, over the next year or two with so much uncertainty.
But this is a long-term valuation model. I’m thinking about decades to come. And I have a lot of confidence in JPMorgan Chase when looking out over the long haul.
The DDM analysis gives me a fair value of $109.54.
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 a valuation that shows a severely undervalued stock.
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 JPM as a 4-star stock, with a fair value estimate of $113.00.
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 JPM as a 4-star “BUY”, with a 12-month target price of $115.00.
I think we have a pretty tight consensus here. Averaging the three numbers out gives us a final valuation of $112.51, which would indicate the stock is possibly 23% undervalued.
Bottom line: JPMorgan Chase & Co. (JPM) is a financial powerhouse and best-in-breed company. It’s a tough time to invest in a business like this, which is precisely why it might just be the best time to invest in it. With a ~4% yield, double-digit dividend growth, a modest payout ratio, and the potential that shares are 23% undervalued, this stock is a very compelling long-term investment idea for dividend growth investors.
Note from DTA: How safe is JPM’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 60. 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, JPM’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
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