This article first appeared on Dividends & Income

There are some business models out there that are totally expendable.

I remember seeing an advertisement for a pet rock.

Yes, a rock in a box marketed as a “pet”.

The company making pet rocks could disappear tomorrow and the world would carry on all the same.

However, there are a number of other fine businesses out there that keep society functioning – and massively profit from their role in that.

Investors who attach their capital to these businesses should be positioned to do very well over the long run, assuming they do their homework and buy at the right prices.

I’ve attached my capital to a number of great businesses.

That allowed me to build my FIRE Fund.

Jason Fieber's Dividend Growth PortfolioMy FIRE Fund is my real-money stock portfolio.

And it generates enough five-figure passive dividend income for me to live off – in my 30s.

Indeed, I quit my job at 32 and basically retired at a very young age.

As I share in my Early Retirement Blueprint, I went from below broke at age 27 to financially free and retired at 33.

There’s an investment strategy that’s at the heart of the Blueprint.

It’s dividend growth investing.

This strategy advocates buying and holding shares in world-class enterprises that pay reliable and rising cash dividends to shareholders.

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

I love this strategy for a lot of reasons.

There’s nothing quite like waking up to fresh money you didn’t go to sleep with.

Dividends are the “proof in the profit pudding”.

You can’t fake cash.

While this strategy is fantastic for long-term investing, one still has to be methodical with their approach.

Fundamental analysis is very important.

And valuation is critical.

Price is only what you pay. It’s value that 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.

Investing in world-class companies that keep society functioning, and doing so at attractive valuations, can lead to life-changing wealth and passive income over the long term.

The good news about this is, the actual process of valuation isn’t as complex as it might seem.

Fellow contributor Dave Van Knapp has made that process even less complex with Lesson 11: Valuation.

Part of a larger series of “lessons” on DGI, Lesson 11 explicitly 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…

U.S. Bancorp (USB)

U.S. Bancorp (USB) is a bank holding company that offers a diversified mix of financial services, including traditional retail banking, wealth management, commercial banking, and payment services.

Founded in 1863, U.S. Bancorp is now a $55 billion (by market cap) banking giant that employs almost 70,000 people.

Operating as the fifth-largest American bank by deposits, U.S. Bancorp has branches in 25 different states (primarily in the Midwest and West).

The world would certainly continue to turn if pet rocks suddenly disappeared.

But society as we currently know it would practically collapse without our modern banking structure.

And as one of the largest banks in the United States (which happens to be the largest economy in the world), U.S. Bancorp is massively profiting from their position of financial might.

Don’t take just my word for it, though.

Warren Buffett, arguably the greatest investor to ever live, is a longtime shareholder in U.S. Bancorp.

He has over $5 billion invested in this super-regional bank, as you can see over at the Warren Buffett Tracker.

The core banking business model is one of the best out there.

That’s due to the float.

Access to large sums of low-cost and low-risk capital – deposits – can be used to fund loans and other ventures that generate attractive returns. It’s earning money off of other people’s money.

Pay one rate on the cash you take in. And charge a much higher rate on the cash you lend out.

Easy-peasy profit.

Now, the current pandemic has some political and financial ramifications for large banks in America.

This will end up putting a lid on banks’ dividends and growth over the near term.

But don’t let that blind you to the fact that large American banks are money machines over the long term.

And money machines like this one tend to spit out lots and lots of dividends – dividends that are routinely growing.

Dividend Growth, Growth Rate, Payout Ratio and Yield

U.S. Bancorp has already increased its dividend for nine consecutive years.

The five-year dividend growth rate, at 10.0%, is impressive.

It’s especially impressive when you pair that with the stock’s starting yield of 4.65%.

That yield is more than 210 basis points higher than the stock’s own five-year average yield.

With a payout ratio of 34.3%, this is a well-covered dividend.

That said, banks’ near-term earnings are collapsing in the face of capital reserve building to prepare for loan losses.

So what looked like a very healthy bank dividend yesterday can be a dividend in trouble tomorrow.

Just as well, though, some of these provisions could end up being windfalls down the road if losses incurred aren’t as bad as expected.

I’m certain that dividend growth will be muted over the foreseeable future.

On the other hand, you’re getting that much higher starting yield to compensate for the near-term challenges.

Either way, U.S. Bancorp remains a quality financial institution that should do very well over the long run.

Revenue and Earnings Growth

And it’s that long-run growth that investors should care about, because it tells you a lot about what the stock might be worth right now.

I’m going to build out a forward-looking growth trajectory for the bank, which will later help us estimate intrinsic value.

This trajectory will partially rely on what the company has done over the last decade in terms of top-line and bottom-line growth.

I’ll then compare those long-term results with a near-term professional prognostication for profit growth.

Blending the proven past with a future forecast like this allows us to build out reasonable expectations.

U.S. Bancorp has increased its revenue from $16.458 billion in FY 2010 to $22.883 billion in FY 2019.

That’s a compound annual growth rate of 3.73%.

Meanwhile, earnings per share advanced from $1.73 to $4.16 over this period, which is a CAGR of 10.24%.

In my view, this is impressive.

The last decade has been extremely tough for banks – record-low interest rates and onerous regulations have weighed on the entire industry.

Yet U.S. Bancorp is putting out double-digit bottom-line growth.

A lot of the excess bottom-line growth came down to operational excellence, with improving margins and buybacks moving the needle.

For perspective on the buybacks, the outstanding share count is down by 18% over the last decade.

Looking forward, CFRA is forecasting that U.S. Bancorp will compound its EPS at an annual rate of 5% over the next three years.

They cite net interest margin compression, decline in merchant processing fees, and overall economic uncertainty as key headwinds and risks.

But the bank’s diversified revenue stream, resilient mortgage exposure, and the opportunity to strike on accretive acquisitions while moving to a more digital business model are all tailwinds to consider.

I think that’s a pretty fair assessment of U.S. Bancorp in this environment.

We’re talking about a 50% haircut in profit growth over the next few years, relative to what the bank has enjoyed previously.

It’s significant. But it seems warranted here.

Nonetheless, we’re not talking about any kind of imminent collapse here.

And while dividend growth will be capped, U.S. Bancorp should be positioned well to aggressively grow the dividend once things start to clear up.

Financial Position

Moving over to the balance sheet, the bank has an outstanding financial position.

They have $495 billion in total assets against $443 billion in total liabilities.

Their senior unsecured debt has the following credit ratings: A1, Moody’s; A+, S&P; AA-, Fitch.

We’re talking about numbers here that are well into investment-grade territory.

The bank’s profitability is extremely robust, easily competing with the very best banks out there.

Over the last five years, the firm has averaged annual net margin of 28.07% and annual return on equity of 14.26%. Net interest margin came in at 3.06% last year.

There’s a lot to like about U.S. Bancorp as a business, which is probably why Buffett is so heavily invested.

The float that a bank builds up is a powerful tool. And the “sticky” nature of deposits means this competitive advantage is not easily lost once gained.

Plus, U.S. Bancorp is one of the largest banks in America, creating scale where scale matters.

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 pandemic-induced recession will hurt banks through loan losses.

Recessions hurt banks twice over: The lower economic activity reduces earnings, while loan losses stress the balance sheet.

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.

And there’s political risk for banks, making buybacks and dividend increases “frowned upon” right now – even if those moves are financially viable.

With these risks known, I still think U.S. Bancorp is a fantastic long-term investment idea.

The 35% YTD drop in the stock’s price has made it look even more fantastic…

Stock Price Valuation

The stock is available for a P/E ratio of 11.85.

That’s significantly lower than the broader market’s earnings multiple.

It’s also well off of the stock’s own five-year average P/E ratio of 14.0.

Then there’s the cash flow multiple of 9.8, which is much lower than the three-year average P/CF ratio of 12.4.

And the yield, as noted earlier, is substantially 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 9% discount rate (to account for the yield) and a long-term dividend growth rate of 5.5%.

That’s a rather low DGR for a quality bank like this, but near-term political and financial issues will limit dividend raises for at least the next year or so.

The long-term picture remains quite bright, and I think averaging out that dividend growth over decades will likely be higher than what I’m modeling in.

But I’d rather err on the side of caution, especially with a 100-year event currently upon us.

The DDM analysis gives me a fair value of $50.64.

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.

My analysis shows a very 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 USB as a 4-star stock, with a fair value estimate of $45.00.

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 USB as a 4-star “BUY”, with a 12-month target price of $42.00.

I came out on the high end, but we all agree that the stock is cheap. Averaging the three numbers out gives us a final valuation of $45.88, which would indicate the stock is possibly 22% undervalued.

Bottom line: U.S. Bancorp (USB) is one of the largest and most profitable banks in all of America. Warren Buffett has over $5 billion invested in this bank for good reasons. With a 4%+ yield, low payout ratio, double-digit dividend growth, and the potential that shares are 22% undervalued, dividend growth investors may want to consider investing alongside Warren Buffett and buying this stock.

-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 USB’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 55. 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, USB’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.

We’re Putting $2,000 / Month into These Stocks
The goal? To build a reliable, growing income stream by making regular investments in high-quality dividend-paying companies. Click here to access our Income Builder Portfolio and see what we’re buying this month.

Source: Dividends and Income