This article first appeared on Dividends & Income on Friday.
I’ve been investing for almost a decade.
So much in the investment community has changed in such a short period of time.
One of the biggest changes I’ve experienced has been the way we think about investing in technology.
That change in thinking spawns from the way we now use technology.
When I began investing, back in 2010, Warren Buffett was infamous for his aversion to technology.
But Apple Inc. (AAPL) is now by far the largest holding in the $200+ billion common stock portfolio Buffett oversees for Berkshire Hathaway Inc. (BRK.B).
That’s how much things have changed.
And I, too, have changed.
I was once concerned about the long-term durability of tech companies.
But I’m now invested in a variety of technology companies through my personal stock portfolio, which I call the FIRE Fund.
That’s an investment strategy that advocates buying and holding shares in world-class enterprises that are paying shareholders reliable and rising cash dividends.
You can find more than 700 US-listed stocks that have raised dividends each year for at least the last five consecutive years by checking out the Dividend Champions, Contenders, and Challengers list.
Dividend growth investing is so effective that I used it to go from below broke at age 27 to retired at only 33, as I describe in my Early Retirement Blueprint.
Technology is rapidly transforming our world.
There’s a lot of money to be made from that, which lends itself to reliable and rising dividends.
But this strategy does require an investor to analyze and value a business before investing.
The valuation aspect can be particularly critical.
Price is what you pay. Value is what 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.
Investing in the tech transformation by buying high-quality tech stocks at attractive valuations can lead to a lot of wealth and passive income over time.
Intrinsic value, fortunately, is not all that difficult to estimate.
Fellow contributor Dave Van Knapp has made it even easier via Lesson 11: Valuation.
Part of an overarching series on dividend growth investing, this lesson provides a valuation template 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…
Cisco Systems, Inc. (CSCO) is the world’s leading designer, manufacturer, and supplier of data networking equipment and software.
Founded in 1984, Cisco Systems has grown into a $197 billion (by market cap) tech giant, employing over 75,000 people globally.
The company operates across five groups: Infrastructure Platforms, 58% of FY 2019 sales; Services, 25%; Applications, 11%; Security, 5%; and Other Products, 1%.
Cisco Systems is, essentially, an investment in tech infrastructure.
Without that infrastructure, you’re not able to jump on the Internet and read this article.
It’s the major supplier of switches, routers, firewalls, and supportive networking products. The company’s various products and services are vital for network performance and security.
And as the Internet morphs into the Internet of Things, a ubiquitous interconnection of computing devices into everyday objects, the company’s products and services will become even more critical.
The importance of these products and services should lead to more profit.
And more profit should lead to more dividends.
Dividend Growth, Growth Rate, Payout Ratio and Yield
Cisco has already increased its dividend for 10 consecutive years.
Sure, not the longest streak around.
But what they lack in track record, they more than make up for in growth.
The five-year dividend growth rate is 13.3%.
And that’s a lot of growth when you pair it with the stock’s starting yield of 3.10%.
This yield is slightly higher than the stock’s own five-year average.
With a payout ratio of 56.9%, this dividend is secure and in a position to continue growing.
Revenue and Earnings Growth
Indeed, it’s that future growth that today’s investors care about and are buying into.
Thus, I’ll now build out a forward-looking growth trajectory estimate for Cisco.
This will rely partially on what Cisco has already done over the long term in terms of top-line and bottom-line growth.
Then I’ll compare that 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 Cisco might be going.
Cisco grew its revenue from $40.040 billion in FY 2010 to $51.094 billion in FY 2019.
That’s a compound annual growth rate of 2.93%.
I usually like to see a mid-single-digit top-line growth rate from a mature business like this.
Admittedly, they fell slightly short.
However, the company bought back a lot of stock in order to produce better bottom-line growth.
The company’s earnings per share advanced from $1.33 to $2.61 over this period, which is a CAGR of 7.78%.
That’s closer to the kind of growth I’d expect from a company of Cisco’s caliber.
In addition to buybacks, margins have expanded nicely over the last few years.
Looking forward, CFRA is anticipating that Cisco will compound its EPS at an annual rate of 3% over the next three years.
I last looked at CFRA’s three-year EPS growth prediction for Cisco in late February. It was at 5%.
That was, of course, right as the pandemic was really coming on.
I thought that was a fair, if conservative, estimate.
Knocking it down to 3% seems to be too conservative, in my view.
With the work-from-home revolution (even if only temporary) triggering an accelerated uptake/adoption of technology, Cisco is actually positioned very well in this environment.
CFRA cites a challenging Chinese market as a key headwind. They also note project cancellations from small- and medium-sized businesses.
On the flip side, CFRA points to a variety of tailwinds benefiting Cisco.
These include rising bandwidth consumption, high demand for data center solutions, and the migration to cloud
The pandemic is hurting a lot of businesses.
But Cisco actually stands to come out ahead.
I see the worst-case scenario as the whole thing being a neutral event for Cisco, and that’s not bad at all.
Dividend growth could certainly be middling over the next few years, but the long-term prospects remain great.
Moving over to the balance sheet, Cisco Systems maintains a fantastic financial position. Their balance sheet is a fortress.
The long-term debt/equity ratio is 0.43, while the interest coverage ratio is approximately 18.
If that’s all there was, it’d be impressive.
But there’s more to the story.
The company has more than $33 billion in total cash (as of the end of last FY).
This balance sheet gives them defense in an uncertain environment, while also allowing for the opportunity to be selectively offensive. They can be nimble and scoop up fast-growth companies by virtue of their immense cash hoard.
Their profitability, as one might expect, is extremely robust.
Over the last five years, the firm has averaged annual net margin of 16.54% and annual return on equity of 15.63%.
Again, though, there’s more to the story.
Fiscal year 2018 was an aberration, artificially lowering the averages.
In truth, Cisco is routinely showing a net margin of over 20%, which is fantastic.
I see this is a great business that’s positioned about as well as they can be.
Patents, technological know-how, the necessity of their products, and switching costs are all durable competitive advantages for the company.
Of course, there are risks to consider.
Litigation, regulation, and competition are omnipresent risks in every industry.
The very nature of the business model is also a clear risk, as technology changes very quickly.
As a big enterprise player, Cisco is exposed to the pandemic.
And the souring of US-China relations have been, at times, centered around technology. This creates unusual geopolitical risk.
Overall, I don’t see Cisco as a high-risk investment.
At the right valuation, this could be a very intelligent long-term investment.
Well, the valuation looks pretty compelling here…
Stock Price Valuation
The P/E ratio on the stock is sitting at 18.35.
It’s difficult to compare this to the stock’s recent norms. GAAP numbers have been volatile and caused fluctuations in the P/E ratio.
However, that is well below where the broader market is at.
In addition, the P/CF ratio is 12.7.
That’s pretty favorable in comparison to the stock’s own three-year average P/CF ratio of 14.3.
And the stock’s yield, as noted earlier, is higher than its own 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 7%.
That DGR is lower than the company’s own long-term growth for both EPS and its dividend.
With a moderate payout ratio and a lot of cash, there’s a massive runway in place for dividend growth.
However, I’m also factoring in CFRA’s near-term EPS growth forecast, as well as broader challenges on the enterprise side.
I think it’s certainly plausible that Cisco grows its dividend at a rate higher than this, but I think it makes sense to be cautious.
In my view, dividend raises over the next few years might be on the low end, with things picking back up again within the next 12-24 months and averaging out nicely.
The DDM analysis gives me a fair value of $51.36.
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 a pretty cautious valuation model, the stock still looks at least modestly 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 CSCO as a 3-star stock, with a fair value estimate of $48.00.
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 CSCO as a 4-star “BUY”, with a 12-month target price of $52.00.
I came out very close to where CFRA is at. Averaging the three numbers out gives us a final valuation of $50.45, which would indicate the stock is possibly 9% undervalued.
Bottom line: Cisco Systems, Inc. (CSCO) is a high-quality tech company with excellent fundamentals across the board. With a market-beating dividend, a moderate payout ratio, double-digit dividend growth, a lot of cash on the balance sheet, and the potential that shares are 9% undervalued, this could be a rare opportunity to pick up a quality tech stock at a discount.
P.S. If you’d like access to my entire six-figure dividend growth stock portfolio, as well as stock trades I make with my own money, I’ve made all of that available exclusively through Patreon.
Note from DTA: How safe is CSCO’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 91. 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, CSCO’s dividend appears Very Safe with a very unlikely risk of being cut. Learn more about Dividend Safety Scores here.
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Source: Dividends and Income