This article first appeared on Dividends & Income on Friday.

Warren Buffett has taught me a lot about life and investing.

One of his biggest lessons has to do with how an outlook affects pricing.

If the outlook is rosy, you’re going to pay high prices.

Conversely, pessimism will lead to cheap asset prices.

While it’s undoubtedly scary to invest when the sky seems like it’s falling, that’s actually the best time to buy high-quality assets for the long term.

Well, the sky started to fall a few months ago.

And high-quality assets have become much cheaper.

This is an opportunity to build your portfolio out, grow your wealth, and increase your passive income.

I’ve certainly been taking advantage, adding stocks to my very own FIRE Fund.

Jason Fieber's Dividend Growth PortfolioThat’s my real-money, six-figure stock portfolio.

It generates enough five-figure passive dividend income for me to live off of.

Not only that, it does so while I’m still in my 30s – as I lay out in my Early Retirement Blueprint.

Indeed, I retired at just 33 years old

I did so by applying Buffett’s timeless lessons and combining them with the strategy of dividend growth investing.

This strategy advocates buying and holding shares in world-class enterprises paying reliable and rising cash dividends.

The Dividend Champions, Contenders, and Challengers list reveals more than 700 US-listed stocks that have increased dividends each year for at least the last five consecutive years.

Dividend growth investing takes everything great about long-term investing and supercharges it.

As great as this strategy is, you still have to be thoughtful about both business quality and valuation.

Valuation is particularly important to the success of an investment.

This is something Buffett has repeatedly stressed over the years.

Price is only what you pay, but value is what you actually 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.

Buying high-quality dividend growth stocks on the cheap, because everyone else is pessimistic, can lead to a tremendous amount of wealth and passive income over the long term.

But you have to be brave.

And you have to know what a stock is worth.

The good news is that estimating intrinsic value isn’t as hard as it might seem.

Fellow contributor Dave Van Knapp even put together an excellent valuation template that you can apply to almost any dividend growth stock out there.

You can access it via Lesson 11: Valuation, which is actually part of a more holistic series on dividend growth investing as a whole.

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…

Federal Realty Investment Trust (FRT)

Federal Realty Investment Trust (FRT) is an equity real estate investment trust that owns and manages real estate in eight major US markets, with a focus on shopping centers.

Founded in 1962, their portfolio of over 100 properties features over 3,000 tenants, 24 million square feet, and 2,700 residential units.

Their eight markets are: NYC, Philadelphia, Boston, Washington D.C., Chicago, Miami, Los Angeles, and Silicon Valley. Washington D.C. is their largest market by number of properties.

As of December 31, 2019, they had a 94.2% lease rate and an occupancy rate of 92.5%.

The REIT primarily focuses on mixed use/urban properties and grocery-anchored shopping centers.

When you look at their properties, it’s clear that Federal Realty has concentrated itself in some of the most desirable US markets where high-income households with disposable income are prevalent.

I noted earlier that a rosy outlook leads to high prices.

The outlook was extremely rosy less than a year ago.

And this stock’s price, at over $140/share as recently as October 2019, reflected that optimism.

The sky is now falling, people are scared, and the stock’s price is now below $80/share.

You don’t need me to tell you which price is more attractive.

While the near-term prospects for businesses in general aren’t great – the pandemic is currently still in full swing – it’s not like Federal Realty’s properties have suddenly disappeared or become worthless.

Those properties will drive rental income for years to come, as well as dividends.

Speaking of which, Federal Realty has one of the most impressive dividend growth track records in existence.

Dividend Growth, Growth Rate, Payout Ratio and Yield

The company has increased its dividend for 52 consecutive years.

There are less than 30 companies in the S&P 500 that have increased dividends for 50 or more years; Federal Realty is the only REIT to have done so.

The 10-year dividend growth rate is 4.6%, which is solid.

Moreover, the much lower price has led to a much higher starting yield.

The stock yields 5.59%.

That’s borderline insane for the quality.

For perspective, the stock’s five-year average yield is 3.0%.

We’re talking about a spread of almost 260 basis points here.

The payout ratio, at 67% of TTM FFO/share, is on the conservative side for REITs, indicating one of the more safe dividends in all of real estate.

However, the payout ratio is a backward-looking metric.

And Federal Realty, like pretty much every other REIT, has been suffering and collecting far less than 100% of billed rents.

The company recently announced that it has collected less than 60% of May’s billed rent – ahead of April, but still not great.

On the other hand, this is known news and the near-term issues have pushed the stock’s valuation down significantly.

This isn’t the kind of super safe dividend that, say, Microsoft Corporation (MSFT) offers. But you’re also getting that high yield.

Revenue and Earnings Growth

All that said, long-term investors care most about future results.

We’re putting today’s capital to work for decades of growth.

And it’s all of that future growth that helps us to estimate the present value of a stock.

Thus, I’ll now build out a growth trajectory for Federal Realty, which will later help us value the shares.

I’ll first show you what the REIT has 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 profit growth.

Blending the proven past together with a future forecast should help us determine a reasonable growth path for the business.

Federal Realty grew its revenue from $545 million in FY 2020 to $936 million in FY 2019.

That’s a compound annual growth rate of 6.19%, which is great.

However, we have to keep in mind that a REIT is legally obligated to pay out at least 90% of taxable income in the form of a dividend, limiting the amount of capital it can retain to fund growth.

A REIT typically issues debt and shares to fund growth. The dilutive nature of share issuance means it’s extremely important to look at growth on a per-share basis with any REIT.

And it’s not earnings per share we’re looking at.

Rather, it’s funds from operations.

FFO is a measure of cash generated by a REIT, which adds depreciation and amortization expenses back to earnings.

The company grew its FFO/share from $3.90 to $6.17 over this 10-year period, which is a CAGR of 5.23%.

FFO/share almost kept up with absolute revenue growth.

I think this is a very reasonable rate of per-share growth, especially when you’re pairing it with that starting yield of over 5%.

Looking forward, CFRA believes the REIT will compound its FFO/share growth at a rate of 15% over the next three years.

I almost wonder if that’s a typo, because there’s nothing indicating that the company will be able to muster that.

Federal Realty has one of the best real estate track records you’ll find. There’s no question about it.

However, the pandemic has been a severe headwind. Rental collection has been challenged like never before. And I think that will weigh on results for years to come.

I wouldn’t expect much, if any, growth over the next few years.

But as an investor who’s always thinking about decades into the future, I think Federal Realty is positioned about as well as anyone in real estate.

And they simply don’t need to produce heaps of growth to produce acceptable total return. That’s because the yield, relative to the rate environment, is so high.

The big question, though, is the sustainability of the dividend, at least in the near term. And that will play out over the next 6-12 months.

Financial Position

Moving over to the balance sheet, Federal Realty has one of the best balance sheets in the entire industry.

They have $4.3 billion in total liabilities against $6.8 billion in total assets.

It’s an A-rated balance sheet, sporting an A- from Standard & Poors and an A3 from Moody’s.

And with no tenant comprising more than 3% of annualized base rent, their balance sheet risk has been managed well.

There’s a lot to like about Federal Realty, especially if you’re looking for more exposure to real estate.

It’s one of the highest-quality REITs out there, yet the stock has been beat to a pulp.

This has created a rare opportunity in terms of valuation.

Of course, there are risks to consider.

Regulation, litigation, and competition are omnipresent risks in every industry.

Real estate is highly cyclical. Tenant health and demand for real estate are dependent on the broader economy. With a recession upon us, real estate demand will be depressed in the near term.

As a REIT, due to the capital structure, they must consistently rely on external funding.

This can compound problems in recessions, since the return on equity issuance (when prices are down) is often much lower.

And Federal Realty has concentrated itself in a way that many other REITs have not. Their markets have historically been among the strongest in the United States, but a near-term flee from urban centers will put stress on demand.

Even with these risks in mind, Federal Realty still looks like a promising long-term investment.

And with the 40% YTD drop in stock price, the valuation makes it look even more promising…

Stock Price Valuation

The stock is trading hands for a P/FFO ratio of 11.99.

The P/FFO ratio is analagous to the more common P/E ratio.

That’s incredibly low for a quality business. And it’s obviously well below the broader market’s earnings multiple.

We can also look at straight cash flow.

The stock’s P/CF ratio, at 11.9, is almost half that of the stock’s three-year average P/CF ratio of 20.

And the yield, as noted earlier, is significantly 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 an 8% discount rate (to account for the high yield) and a long-term dividend growth rate of 3%.

That DGR is on the very low end of what I normally account for, but I think this is a case that warrants that kind of caution.

Federal Realty’s dividend growth was slowing even before the pandemic – the last dividend increase was ~3%.

And the recent difficulties with collecting rent do not engender enthusiasm. Plus, there’s been a more recent fleeing from urban US markets.

I think the long-term prospects remain very strong, but near-term results will likely weigh on the stock price and overall dividend growth.

The DDM analysis gives me a fair value of $86.52.

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 think my valuation was very much on the conservative side, yet the stock still looks 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 FRT as a 4-star stock, with a fair value estimate of $100.00.

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 FRT as a 3-star “HOLD”, with a 12-month target price of $85.00.

My valuation was extremely close to where CFRA is at. Averaging the three numbers out gives us a final valuation of $90.51, which would indicate the stock is possibly 20% undervalued.

Bottom line: Federal Realty Investment Trust (FRT) is a high-quality company that has concentrated itself in only the most in-demand markets. With a rare track record of over 50 consecutive years of dividend raises, a yield of well over 5%, a moderate payout ratio, and the potential that shares are 20% undervalued, this could be your opportunity to get a great deal on a quality stock while the “sky is falling” and the valuation has been punished.

-Jason Fieber

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 FRT’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, FRT’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

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Source: Dividends and Income