The S&P 500 moved up approximately 11% in November 2020.
That’s the best November the index has ever had.
This sudden surge upward has made it more difficult to find good deals in the market.
However, the market isn’t a monolith that sees all stocks move in the same way.
Deals can still be found by intrepid investors.
I pride myself on being an intrepid investor.
And the long-term rewards of such have been extremely gratifying.
In fact, I was able to retire in my early 30s.
I provide information on how I accomplished that in the Early Retirement Blueprint.
I now live off of the five-figure dividend income my real-money stock portfolio produces for me.
A specific investment strategy helped me build that portfolio.
That strategy is dividend growth investing.
It advocates buying and holding shares in world-class enterprises that pay reliable and rising cash dividends.
The Dividend Champions, Contenders, and Challengers list contains invaluable information on hundreds of US-listed dividend growth stocks.
While the market isn’t a monolith, a rising tide does tend to lift many boats.
As such, many dividend growth stocks are now expensive.
This can lead to subpar returns.
And that’s why a valuation process is as important as ever.
Price tells you only what you pay. Value tells you 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.
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.
Being an intrepid investor and finding quality deals in all market conditions will likely lead to more wealth, passive income, and even financial freedom over the long haul.
Fortunately, being an intrepid investor is easier than ever.
Fellow contributor Dave Van Knapp has helped with the introduction of Lesson 11: Valuation.
One of many “lessons” he’s penned on dividend growth investing, it provides an excellent valuation template that greatly aides investors when it comes to valuing stocks.
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…
Bank of New York Mellon Corp. (BK)
Bank of New York Mellon Corp. (BK) is a global financial services company.
Founded in 1784, Bank of New York Mellon is now a $36 billion (by market cap) financial beast that employs almost 50,000 people.
The bank provides a range of investment management and financial services in more than 100 markets across 35 countries.
Operations are split across two principal business segments: Investment Services and Investment Management.
These two segments contain the bank’s seven different business lines: Asset Servicing, Pershing, Issuer Services, Treasury Services, Clearance and Collateral Management, Asset Management, and Wealth Management.
This is the largest global custody bank in the world, with over $38 trillion in assets under custody and administration. They also have approximately $1.9 trillion in assets under management.
The $16.5 billion acquisition of Mellon Financial by Bank of New York in 2007 created the Bank of New York Mellon that now exists.
The combined enterprise has morphed into a powerhouse bank that provides critical services behind the global banking infrastructure.
In particular, Bank of New York Mellon specializes in institutional services, which includes trade execution, custody, securities lending, and clearance and settlement.
A broad array of accounting and administrative services are also available.
Through industry consolidation and advancements toward sticky custody assets, Bank of New York Mellon has built an enviable business model focused on scalable, fee-based securities servicing and fiduciary businesses.
Indeed, fee revenue accounted for 80% of FY 2019 total revenue.
The bank’s scale and largely fee-based business model positions them well to continue making money and paying out a growing dividend.
Dividend Growth, Growth Rate, Payout Ratio and Yield
As it stands, Bank of New York Mellon has increased its dividend for nine consecutive years.
And the five-year dividend growth rate is 12.3%.
This double-digit long-term dividend growth comes on top of a market-beating yield of 3.04%.
That yield, by the way, is more than 110 basis points higher than the stock’s own five-year average yield.
It’s worth noting, however, that dividend growth is currently on pause.
While the bank has an incredible capability to grow its dividend through thick and thin, they are sometimes prevented from doing so by outside forces.
The Federal Reserve stepping in with extreme stress tests and forbidding the increase of bank dividends during the pandemic is an example of that.
I expect the dividend to continue growing as soon as it’s allowed.
In the meantime, the dividend is protected by a very low payout ratio of 27.3%.
These dividend metrics are extremely solid across the board.
Revenue and Earnings Growth
That said, these backward-looking numbers only get you so far.
We risk and invest today’s capital for tomorrow’s rewards.
Thus, I’ll now build out a forward-looking growth trajectory for the bank, which will later help us estimate the intrinsic value of the stock.
I’ll first show you what the company 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.
Combining the proven past with a future forecast in this manner should help us come to a reasonable conclusion regarding the company’s growth path.
Bank of New York Mellon increased its revenue from $13.875 billion in FY 2010 to $15.434 billion in FY 2019.
That’s a compound annual growth rate of 1.19%.
Not terribly impressive.
The last decade has been really tough for banks in general, due to various factors like low interest rates and tough regulations.
While Bank of New York Mellon has a fee-based business based on banking infrastructure, they’re still exposed to broader headwinds within banking.
Meanwhile, earnings per share grew from $2.06 to $4.51 over this period, which is a CAGR of 9.10%.
Not only is this great but it’s been almost completely secular. The bank tends to rack up YOY increases in EPS like clockwork.
There is substantial excess bottom-line growth here, which is largely thanks to big buybacks and a healthy expansion in margins.
Regarding the buybacks, the bank reduced its outstanding share count by 22% over the last 10 years.
Looking forward, CFRA believes that Bank of New York Mellon will compound its EPS at an annual rate of 2% over the next three years.
In my view, this is a pessimistic take on the bank’s near-term earnings growth potential.
CFRA cites the persistence of low interest rates, an overall economic contraction driven by COVID-19, and competitive pressure in the asset servicing space as prime headwinds.
On the other hand, diverse business lines, a margin expansion story, and the bank’s positioning in a complex regulatory field all work to the company’s benefit.
Bank of New York Mellon has been resilient throughout the pandemic. Their Q3 FY 2020 report showed revenue down less than 1% YOY. That’s mostly because the fee revenue barely budged.
Once the US economy starts to move again, so will the bank. Low interest rates hurt the business model, but I think they can do better than 2% EPS growth annually from here. The prolific buybacks alone can drive a lot of EPS growth, even off of flat revenue.
With a very low payout ratio, I believe they’ll be capable of easily delivering mid-single-digit dividend growth over the long run.
Moving over to the balance sheet, the bank has a solid financial position.
They have $381.5 billion in total assets against $339.8 billion in total liabilities.
The Bank of New York Mellon’s long-term senior debt features credit ratings well into investment-grade territory: S&P, AA-; Moody’s, Aa2; and Fitch, AA.
Also, consider that Warren Buffett has given his seal of approval to this bank.
Berkshire Hathaway Inc. (BRK.B) owns a longtime position in Bank of New York Mellon that’s currently worth about $3 billion.
The bank’s profitability is strong. And margins have been expanding nicely.
I see this as a compelling way to play the value in banks, without going head over skis into the headwinds from low interest rates. The bank’s unique business model and fee-based structure offers a lot to like.
I want to reiterate that this company has been around for more than 230 years. One of its co-founders was Alexander Hamilton – you know, one of the Founding Fathers of the United States. They’ve more than proven their durability.
With global scale, its positioning in banking infrastructure, entrenched relationships around sticky assets, and unique know-how around regulatory matters, the bank does feature competitive advantages.
Of course, there are risks to consider.
Regulation, litigation, and competition are omnipresent risks in every industry.
An environment with persistently low interest rates is a challenge for the bank.
Ongoing downward pressure in fees across banking will likely somewhat stymie the company’s growth trajectory.
The bank’s asset management business faces pressures of its own from the rise of low-cost, passive alternatives.
And the total economic fallout from the pandemic remains unknown. Any lasting economic scars will affect the bank.
Overall, I think this is a quality business with one of the all-time best track records for longevity.
At the right valuation, it could be an attractive long-term investment.
With the stock down almost 20% YTD, I think the valuation is now quite appealing…
Stock Price Valuation
The stock is trading hands for a P/E ratio of 8.96.
That’s less than half of the broader market’s earnings multiple.
It’s also way off of the stock’s own five-year average P/E ratio of 15.3.
Keep in mind, I’m not using adjusted earnings here. These are GAAP numbers, making things highly comparable.
At 0.9 times book value, it’s not even at book.
The P/CF ratio of 10.7 is below its three-year average of 12.8.
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 a 10% discount rate and a long-term dividend growth rate of 7%.
That’s well below both their five-year dividend growth rate and their 10-year EPS growth rate.
But I think the drop is reasonable.
This DGR hearkens back to what I wrote earlier about the bank’s dividend growth potential from buybacks and the low payout ratio. Those two factors alone can propel plenty of dividend raises.
However, moderating bottom-line growth from the various challenges will also cap the upside.
The bank could certainly do even better than this. But I’d rather err on the side of caution.
The DDM analysis gives me a fair value of $44.23.
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 conservative, yet the stock looks cheap anyway.
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 BK as a 4-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 BK as a 3-star “HOLD”, with a 12-month target price of $40.00.
I came out almost exactly in the middle. Averaging the three numbers out gives us a final valuation of $44.08, which would indicate the stock is possibly 8% undervalued.
Bottom line: Bank of New York Mellon Corp. (BK) is a global financial powerhouse with roots that date back to the founding of the United States of America. Their longevity is unmatched. With a market-beating dividend, double-digit long-term dividend growth, a very low payout ratio, and the potential that shares are 8% undervalued, this could be an opportunity to load up on a Buffett-approved 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 BK’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, BK’s dividend appears Borderline Safe with a moderate risk of being cut. Learn more about Dividend Safety Scores here.
This article first appeared on Dividends & Income
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